Risk eng


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Risk eng

  1. 1. THEME Risk Engineering Chart - 1 R isk Engineering re- fers to unanticipated changes attributed to company’s assets, liabilities and operating income. Any business decision has got two fundamental parameters – ‘Risk’ and Return. Risk Engi- neering deals with establishing now no longer be merely a The SOX goes much deeper a trade off between these two management concept, which than just the accuracy of finan- parameters so as to maximise the management applies inter cial projections; it touches on shareholders’ wealth. many areas that affect project management. It is not too late Sapan Anil The only thing certain in these changing times is ‘un- to have the waves of Sarbanes- Sanghani certainty’ and a ‘Risk’ is basically linked to such uncertain- Oxley Act being multiplied inThe author is a member ties. Although the future and risk cannot be predicted 100 Indian Business World. of the Institute andworking as Officer -- F & per cent, still ‘precaution is always better than cure’. And the “Risk Engineering is like A, Niko Resources Ltd. way we manage and mitigate such risks is broadly called ‘Risk She can be reached at ‘Going Back To The Future’. Engineering’. Risk Engineering is an ‘Art’ and not ‘Science’. sapan@nikoindia.com It’s not about conquering the There is no specific, defined, well-delineated or scientific way by which risk can be engineered. It can be said that Risk En- future but managing the fu- gineering is ‘Scientific Art’ or ‘Artistic Science’. Read on to ture by taking suitable actions take a peek into the depths of the concept. in present. Change is something, which is permanent; in this Today, every business is nally for purpose of mitigating change uncertainty is some- exposed to some or the other its exposure to Risk. For In- thing, which is certain; in this risk, which affects its profit- stance Clause 49 of the Listing uncertainty Risk Engineer- ability and cash-flows. Any Agreement has been amended ing is a measure for survival, business cannot be fully safe- wherein the corporates are prevention, growth, expansion guarded against the uncertain- now required to provide in the and value addition”. ties of future, but it can cer- report on Corporate Gover- The rationale is – Survival tainly take steps to reasonably nance, the Risk Management of the Fittest. hedge itself from future risks. and Risk Mitigation Policies Risk refers to degree of adopted by the management. variability of actual returns from Business Risk The new buzz in US econ- There are many and di- expected returns associated omy is that – Is Poor Project with given assets/investments. versified operational risks in- Management a Crime? The The future is uncertain but still herent in every business. Few answer could be ‘yes’ since now scientific projections are made the Sarbanes-Oxley Act makes Risk Hedging Tools available to prepare for the same. One senior executives criminally li- have been discerned as under. thing that is sure is that risk can able for not making reason- Standard Deviation (d) and seldom be eliminated. With lu- able and sufficient endeavours Coefficient of Variation: crative measures being taken it to identify risks their business These are statistical mea- can only be managed and engi- is exposed and taking mea- sures used to quantify risk. It neered so as to mitigate its ef- sures to mitigate such risks. In measures the variance from fects on the business. the wake of several account- estimations and budgets in re- Risk can broadly be cat- ing scandals the US Congress spect of production, cost and egorised in as Chart - 1. passed a law, referred to as the expenses. Standard Deviation Sarbanes-Oxley Act of 2002 is an absolute measure while Giving Statutory Colours to (SOX), which holds CEOs Coefficient of Variation is a Risk Engineering and CFOs criminally liable for relative model. It is expressed Risk Engineering will relating fraud to shareholders. in the same units as the range October 2005 The Chartered Accountant 559
  2. 2. RISK ENGINEERING WEB560 The Chartered Accountant October 2005
  3. 3. RISK PROFILE Substituting the above values in following equations. Y = mx +c. ∑y = m.∑x + n.c ∑xy = n.∑x^2 + c. ∑x, we get y = 1.243x + 0.666. Thus, profit for year 2005- 06 with weight (x) of 7 should be 9.37 crore and profit for year 2006-07 with weight (x) of 9 should be 11.85. This tool can be extremely useful in projections of future parameters and then compar- ing the actual results with the projections. However, the ba- sic requirement for this tool is that the variable (profit in this case) should follow an increas- ing or decreasing trend. Earned Value Management & Cost Performance Index: This is statistical technique used mainly to gauge performance of the company on the basis of budgeted performance. The significance of this technique in project management and risk hedging is exemplified using following example. For Instance – The bud-of probable outcomes is ex- wherein just by feeding few geted & actual data are aspressed i.e. if you are apply- figures a rough estimate can under: -ing the to evaluate per cent be made of net profit for any Prima Facie the above cata-returns in a project, is ex- future period(s). logued figures manifests thatpressed in per centage terms. The use of Regression the expenditure is withinIt doesn’t directly hedge busi- Analysis is exemplified as the limits and the companyness risks but provides value under: - has performed according toadded information to the de- ∑x=0, ∑xy=87, ∑x^2=70, planned estimates. But thecision makers enabling them ∑y=9, n=6.to make sound decisions andthereby preclude the adversity Rs. In Crores.of any risks. Year Profit WeightsRegression Analysis: This is y x xy x^2also a statistical tool, whichprovides a Decision MakingModel thereby enabling the 1999-00 (5) (5) 25 25decision maker to take sounddecisions. It is based on analy- 2000-01 (3) (3) 9 9sis of past trend and data. This 2001-02 1 (1) (1) 1decision-making model assists 2002-03 4 1 4 1in making accurate future pro-jections and predictions. 2003-04 5 3 15 9 For Instance - Based on 2004-05 7 5 35 25past trend in the net profitof the company, a statisti-cal model can be developed ∑ 9 - 87 70 October 2005 The Chartered Accountant 561
  4. 4. Particulars Budgeted Actual (55/0.75). within (i) specific time frame Amount Amount Schedule Per- (ii) at specified cost and (iii) formance Index is meeting the performance Exploration 100 crore 85 crore akin to CPI except standards. Critical Path Development 120 crore 95 crore that in SPI the Analysis is one of the most formula is Earned lucrative tool for successful Total 220 crore 180 crore Value for a Schedule project execution. Its majorbudgeted amount is for the Pe r iod/Budgeted advantages interalia includesentire project i.e. 100 per cent amount for a Schedule Period. –completion whereas the actual It measures performance of - Comprehensivecompletion is say, only 75 per project for particular period view of entire proj-cent. Hence, the actual com- rather than on cumulative ect.parison should be as under. basis. - Effective time Cost of Per- scheduling. Particulars Budgeted Actual formance Index - Identification of Amount (75 Amount and Schedule critical activities per cent) Performance In- of any project and Exploration 75 crore 85 crore dex are based on continuous focus on the concept of it. Development 90 crore 95 crore ‘Management - Breaking down of Total 165 crore 180 crore By Exception’. project into differ- Management ent components for The realistic figures as has to focus on better control andjuxtaposed above show that only those areas, which do vigilance.the expenditure has in fact not perform according to - Control based onexceeded the budgeted fig- planned estimates. For this Principle of Elimi-ures and the company has purpose, CPI & SPI needs nation.not performed as per planned to be calculated for each line - Optimum Resourceestimates. Thus, the calcula- of cost and also on overall Allocation.tions of the management can basis.go wrong if the decisions Simulation Technique: Simu-are taken based on the first lation is a quantitative tech-table. nique wherein organised In the above table, Rs. series of trial and error ex-165 crore is called Earned periments are conducted toValue out of Rs. 220 crore of predict the future behaviour.the budgeted figures. For Instance if probabi- Cumulative Earned Value/ listic estimates of Turnover,Cumulative Budgeted Amount Net Profit or any other fi-i.e. 165/220 = 0.75 is called nancial parameter are madeCost Performance Index. available, a series of trial andCPI below one is an indicator error experiments can beof unfavourable performance. conducted on these estimatesIt means that for every ru- and reasonable accuracy canpee spent by the company be achieved in making pre-the company achieves value diction about turnover orworth Rs. 0.75. CPI above net profit or any other finan-one is desirable. cial parameter for the future Balance budgeted amount period(s).i.e. Rs. 55 (220-165) divided Critical Path Analysis: It is aby CPI i.e. 0.75 gives the quantitative technique thatbalance expenditure which allows a comprehensive viewshould be incurred if the of the project. A project usu-current performance is as- ally involves a set of activitiessumed to continue in future or jobs that are performed inas well. Thus, the further ex- certain sequence determinedpenditure should be within logically or technologicallyoverall limits of Rs. 73.333 and it has to be completed 562 The Chartered Accountant October 2005
  5. 5. Project Evaluation & Review volatile foreign exchange vantage of forces of demandTechnique [PERT] markets. and supply in currency mar- Critical Path Analysis is The measures available ket. Currency rates betweenincapable of handling un- to hedge against these risks two countries, which are notcertainty in timing, which are common. theoretically determined butis an impediment in turnkey Forward Contracts: For- are based on the forces of de-projects such as oil explora- ward contracts are contractstion. PERT takes care of this mand and supply in the in- to buy or sell foreign cur-uncertainty involved in any rency or crude oil at a speci- ternational market.project. However, for this, fied rate on a specified date. This technique can bemanagement needs to pro- It involves cost in the form more useful in case where avide three kinds of proba- of forward premium. This is company has its holding orbilistic estimates namely the most common technique subsidiary in another coun-– Optimistic, Pessimistic and used today across various in- try with different reportingMost Likely. In short, PERT dustries to hedge against fi- currency. In that case, bothis a combination of Probabil- nancial risks. the company can work outity Distribution and Critical This has been exempli- on suitable policy w.r.t cur-Path Analysis. fied using the following in- rency swaps whereby bothNet Present Value & Profit- stance.ability Index: These are Fi- the companies are benefited Say, Company A is tonancial Tools usually used for make payment of USD 1 and their respective risks aremaking appraisal of Capital million on 31.03.05. On hedged.Budgeting proposals. They 01.01.05 it enters into for- The benefit of this engi-help in justifying financial ward contract when the spot neering tool is exemplified asviability of any capital in- rate is 1 USD = Rs. 44.34. under: -vestment based on the cash The forward rate is 44.50. Suppose Company Aflows provided over the life Thus the contract is at for- (subsidiary or affiliate) incor-of that investment. ward premium of 1.44 per porated in India has availed Estimation of Future cent [(44.50-44.34)/44.50 x loan of Rs. 44,00,00,000Cash Flows would also aid in 12/3 x 100]. from State Bank of India andcompliance with AS-28 ‘Im- Company A will have to Company B incorporated inpairment of Assets’ issued by pay the premium amount ofICAI. Britain (parent) has availed Rs. 14,400 on 01.01.05. Internal Rate of Return: On 31.03.05 A would a loan of USD 1,00,00,000Internal Rate of Return is have to make payment @ 1 from Bank of America. Bothagain a financial tool used USD = Rs. 44.50. Say the the companies decide to en-to measure the financial vi- spot rate on that date was 1 ter in Currency swaps withability of any investment USD = Rs. 44.55. Thus the each other whereby theybased on the return likely to net savings of the company decide to exchange their re-be generated by it. It is the would be as under. spective debts.rate at which present value of Let’s see howfuture cash outflows is equal Savings [Rs. 44.55 – Rs. Rs. 50,000. currency swap canto present value of cash out- 44.50] x 1 million. benefit both offlows. In a way, it is bottom-line rate of return, which ev- Less: forward premium Rs. 14,400. them.ery investment should yield Consider the Net Savings Rs. 35,600.in order to be in better off following rates –situation. 1. 1 USD = Rs. 43.91. Currency Swaps: This in- 2. 1 GBP = Rs. 82.88.Financial Risks volves exchange of company’s 3. 1 GBP = USD 1.88. This can be again classi- receivables or payables de- - If A had not enteredfied into two groups – nominated in foreign curren- in currency swap, it would - Risk associated cy with any other company’s have to pay Rs. 44,00,00,000 with sporadic in- assets or liabilities denomi- to SBI. ternational product nated in a different foreign - If B had not entered prices. currency. It basically involves in currency swap, it - Risk associated with arbitrating and taking the ad- would have to pay GBP October 2005 The Chartered Accountant 563
  6. 6. 53,19,149 [1,00,00,000 A fixed interest payment compared to ABC Ltd. USD / 1.88]. may be swapped (convert- - Both the companies have- After entering into cur- ed) into a floating interest outstanding loan of Rs. rency swap agreement, A rate payment and vice versa. 50 Crore. would have to pay loan of Thus, floating rate borrowers - XYZ has gone for fixed B of USD 1,00,00,000. can swap their commitments interest rate while ABC As a result, cash outflow for fixed rate and vice versa. has gone for floating in- for A would amount A floating to fixed swap terest rate. to Rs. 43,91,00,000. will be taken if the rates are - XYZ expects the interest [1,00,00,000 USD x Rs. expected to increase and rate to fall and is there- 43.91] fixed to floating rate swap fore willing to shift to- Similarly, after entering will be taken if the rate are Floating Interest Rate. into currency swap agree- perceived to fall. - ABC expects the inter- ment, B would have to Let’s understand with est rate to rise and is pay GBP 53,08,880 [Rs. the help of suitable example. therefore willing to shift 44,00,00,000/82.88]. to Fixed Interest Rate. - Thus, the desired inter- XYZ LTD ABC LTD (Ci- est rate for XYZ is MI- (ICICI) tibank) BOR + 0.40 per cent and desired interest rate Fixed Interest Rate 10 per cent 11 per cent for ABC is 11 per cent. Floating Interest Rate MIBOR + 0.40 MIBOR + 0.80 How the Gain is Com- per cent per cent puted? Thus the net gain due to Desired Interest Rates MIBOR + 0.40 per Background if they had not entered cent + 11 per centCurrency Swap Agreement to - XYZ Ltd enjoys high- in IRS Agreement.both the companies would be er creditworthiness as Interest Rates if they 10 per cent + MI- enter into IRS Agree- BOR + 0.80 per ment. cent Gain if they enter into 0.60 per cent IRS Agreement. Both the companies may mutually agree that the gain of 0.60 per cent shall be di- NET BENEFIT = GBP10269 NET BENEFIT = Rs. 900,000 vided between XYZ and Interest Rate SwapAgreements: Interest Rate Swap (IRS)is an agreement between twoparties who exchange inter-est payments based on a no-tional principal amount overan agreed period of time. Thefollowing can be the objec-tives of interest rate swaps.- To protect or alter the in- terest rate on borrowings.- To alter the frequency and size of the cash flow profile. 564 The Chartered Accountant October 2005
  7. 7. ABC say, in the ratio of 2:1, risk where the underlying asset risk is limited to the amount of taking into consideration the can either be foreign currency premium to be paid at the time creditworthiness enjoyed by or international product prices, of buying an option. them. Accordingly, XYZ will both of which are subject to On the other hand, for be benefited by 0.40 per cent volatile movements. the option writer (Seller), the and ABC will be benefited benefits are limited to option by 0.20 per cent. Options: premium received while cost Options are agreements or risk is unlimited. Mechanism wherein the option holder Actual delivery of the un- MIBOR + 0.40 per cent (Buyer) has a right to buy or derlying assets does not take place and the transaction is settled by making payment of the differential amount. In case of options the un- derlying asset can be currency, product prices, interest rates or share prices. The options de- rive their value from the value of their under- Swap Pay-off Table lying assets. Pay to bank Pay to other Receipt Net pay Desired rate Benefit Futures: party from other out cost Futures are party akin to options XYZ 10 per cent MIBOR+0.4 10.40 per MIBOR MIBOR+0.4 0.4 per but unlike op- per cent cent per cent cent tions, the buyer ABC MIBOR+0.8 10.40 per cent MIBOR+0.4 10.80 11 per cent 0.2 per in futures does per cent per cent per cent cent have an obliga- tion to buy or Futures & Options: sell specific quantity of an un- sell specified quantity of un- With avalanche of trading derlying asset at a specified derlying asset at a specified in derivatives market, these price on or before a specified date on or before a specified tools have become favorites date. It is to be noted that the date. The buyer cannot elude of many companies for Risk buyer has a right but does not himself from his obligations Engineering. have an obligation to do so. In in case of futures. In a way, The company can enter a way, the benefits for the buyer the risk in case of futures is into agreement for hedging are unlimited while the cost or equal both for the buyer and the seller. These derivatives can prove to be one of the most lucrative tools for hedging company’s financial risk, as far as product prices in the international market and foreign currency rates are concerned. Many companies have reported huge profits in theLamiya Lokhandwala form of paper gains through efficient Treasury Operations & Risk Management and at the same time hedging its fi- nancial risks. Ë October 2005 The Chartered Accountant 565