This document outlines various types of risks faced by treasury operations including interest rate risk, foreign exchange risk, credit risk, commodity risk, operational risk, liquidity risk, and other risks. It provides details on measuring and managing each type of risk through approaches like sensitivity analysis, scenario analysis, stress testing, value at risk and monitoring key risk indicators. An example is provided to illustrate operational risk from a large trading error at the Tokyo Stock Exchange.

1. TREASURY RISKS

2. TREASURY RISKS
1. Interest rate risk
2. Foreign exchange risk
3. Credit risk
4. Commodity risk
5. Operational risk
6. Liquidity risk
7. Other risks

3. INTEREST RATE RISK
1. Absolute interest rate risk
2. Yield curve risk
3. Reinvestment or refunding risk
4. Embedded options risk

4. • Absolute interest rate risk
– It arises from exposure to a directional (up or
down) change in interest rates

5. Yield Curve Risk
• Arises from changes in the relationship
between ST and LT interest rates
• Usual shape of yield curve is upward sloping
• Steepening or flattening or becoming
downward sloping changes the relationship
• The change in shape changes the interest rate
differential b/w ST and LT maturities
• It impacts borrowing and lending decisions
and therefore profitability

6. Foreign Exchange Risk
• Transaction Risk
• Translation Risk
• Strategic Risk

7. Forex – Transaction Risk
• Arises from transactions reported in the
income statement of a company
• Result of purchases/payments in Forex
• Inventories, royalties, license fees, etc
• Sales in forex

8. Forex – Translation Risk
• It arises when assets, liabilities or profits are
translated from the operating currency into a
reporting currency
• For example the reporting currency of a
parent company

9. Translation Risk - Example
US $ in UK Pound UK Pound
millions Sterling@ Sterling @
1.60 in 1.50 in
millions millions
Gross 1,000 625 667
Assets
Liabilities 250 156 167
Net 750 469 500
Assets
Net 150 97 103
Profit

10. Credit Risk
• Default risk
• Counter party risk
• Sovereign or country risk
• Concentration risk
• Legal risk
– Arises from a possibility that a counter party is not
legally permitted to enter into transactions such
as derivatives transactions

11. Commodity Risk
• Commodity price risk
• Commodity quantity risk
• Issues
– Quality
– Delivery
– Location
– Transportation
– Spoilage
– Shortages, storability

12. Operational Risk
• Human Errors and Frauds
• Processes and procedural risk
– Eg. Use of inadequate controls
– Sarbanes-Oxley act in USA
• Technology and systems risk
– Weakness in technology and systems provide
opportunities for errors, failures, lost data and
fraud

13. Liquidity Risk
• The ability of a firm to maintain adequate
liquidity through Wrk. Cap. Mgt.
• Firm’s capacity to meet its ST obligations
• Ability to buy securities
• Ability to sell securities
• Ability to close out contracts; trading/hedging
• The less liquid a market, the more costly and
difficult to undertake transactions in the mkt.

14. Other Risks
• Basis risk
• Reputation risk
• Equity price risk
• Systemic risk
– Failure of a major financial institution could
trigger a domino effect
– Can also arise from technological failure or a
major disaster

15. Risk Measurement
• Two approaches for risk management
– Day to day or Tactical standpoint
– High level or Strategic view
• It is necessary to have the capability to
monitor risk from both stand points
• Risk management requires both quantitative
and qualitative analysis
• However it cannot be reduced to a simple
– Checklist, a mechanical process or a number

16. Risk Measurement
• Risk assessment is a two part process
– Assessment of likely gain or loss from changes in
market rates or prices
– Assessment of probability of the changes

17. Sensitivity
• Calculate net exposure taking into account
various positions of the organization
• Example
– Exposure to foreign currency
– Track all assets, liabilities, expenses and revenues
in a foreign currency
– Study fluctuations when exchange rate changes
– GAP Analysis

18. Scenario Analysis
• Also called “ What – If – Aanlysis
• Its assesses potential loss by analyzing the
value of an instrument or a portfolio under
different scenarios
• One factor scenarios such as interest rates
• Multifactor scenarios such as changes in
interest rates as well as changes in foreign
exchange rates

19. Scenario Analysis
• Assess performance of a portfolio of bonds
• Portfolio performance might be assessed
under differing differing yield curves
– Parallel shift with rising interest rates
– Parallel shift with declining interest rates
– Steepening of the yield curve
– Flattening of the yield curve
– Scenario with an inversion to part or all of the
yield curve

20. Stress Testing
• Assessment of how exposure might perform
under more extreme conditions
• It may involve changing one or more variables
using major historical price changes
• If test shows unmanageable potential losses
• Strategies can be formulated to deal with
them
• Proper preparation is the key

21. Value at Risk
• The most commonly used measure of market
risk
• It is a systematic methodology to estimate the
potential financial loss for a given period of
time
• It is based on statistical estimates of
probability at a pre-determined confidence
interval

22. Value at Risk
• An estimate of the probability of a loss being
greater than or less than a particular $
amount as a result of market fluctuations
• It is commonly used for portfolios of assets or
for exposures

23. Credit Risk Measurement
• Assessment of probability of counter party
defaulting on its financial obligation
• Exposure at counter party default
• Loss given counter party default which
considers recovery of amounts that reduces
the loss otherwise resulting from default
• Counter party ratings (credit ratings)

24. Credit Risk Measurement
• Notional Exposure
– Notional or contractual or nominal amounts
outstanding sometimes cited as amounts at risk
– In certain derivatives transactions, less than
notional amount may be at risk
– Full contractual amount is potentially at risk
during settlement
• Aggregate Exposure

25. Replacement Cost
• The cost to replicate a transaction at current
market prices
• Assuming no settlement failures if the
derivatives counterparty defaulted on its
obligations

26. Operational Risk – Defined by BIS 2003
• Internal Fraud
• External Fraud
• Employment Practices
• Workplace Safety
• Clients
• Products
• Business Practices
• Damage to Physical Assets
• Business Disruption & System Failures

27. Operational Risk Measurement
• It results from an organization’s exposure to
people, processes and systems
• Such risk management attempts to reduce
probability of loss resulting from frauds or
errors
• Operational risk databases are being used to
measure and manage operational risk

28. Operational Risk
• Potential for operational risk include
– Number of deviations from policy or stated
procedures
– Comments and notes from internal or external
audits
– Levels of staff turnover
– Volatility of earnings
– Unusual complaints from customers and vendors
– Volume of derivatives trade

30. Operational Risk – Example TSE 2005
• During the initial public offering of J-Com on
December 8, 2005, an employee at
Mizuho Securities Co., Ltd. mistakenly typed
an order to sell 610,000 shares at 1 yen,
instead of an order to sell 1 share at 610,000
yen.
• Mizuho failed to catch the error; the Tokyo
Stock Exchange initially blocked attempts to
cancel the order, resulting in a net loss of 347
million US dollars to be shared between the
exchange and Mizuho.

31. Operational Risk – Example TSE 2005
• Both companies are now trying to deal with
their troubles: lack of error checking, lack of
safeguards, lack of reliability, lack of
transparency, lack of testing, loss of
confidence, and loss of profits.
• On 11 December, the TSE acknowledged that
its system was at fault in the Mizuho trade. On
21 December, Takuo Tsurushima, chief
executive of the TSE, and two other senior
executives resigned over the Mizuho affair.