CA Final May 2023 Suggested Answers Paper 6A Risk Management (Old Scheme)

FOR CA FINAL EXAM PREPARATION

CA Final 2023
Suggested Answers ·
Paper 6A Risk
Management (Old
Scheme)
EXAM YEAR TYPE

CA Final 2023 Suggested Answers
SUBJECT DATE

Paper 6A Risk Management (Old Scheme) May 2023

Notes · Sample Papers · Previous Year Papers · Mock Tests

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or otherwise of the answers published herein.

Further, in the Elective Papers which are Case Study based, the solutions have been worked

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out on the basis of certain assumptions/views derived from the facts given in the question or

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. to work out the solution to the case studies
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language used in the question. It may be possible

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in a different manner based on the assumptions

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2 FINAL EXAMINATION: MAY, 2023

PAPER – 6A – RISK MANAGEMENT
The Question Paper comprises five case study questions. The candidates are required
to answer any four case study questions out of five.
Answers in respect of Multiple-Choice Questions (MCQs) are to be marked on the OMR
Answer Sheet as given on the Cover Page of the answer book.
Answer to MCQs, if written inside the descriptive answer book, will not be evaluated.
Candidates should answer the Case Study Questions as selected by them in totality i.e. MCQ
as well as descriptive Question of the same Case Study Question.
Candidates are not permitted to answer MCQs of one Case Study Question and the
descriptive questions of another Case Study Question and vice-versa.
Candidates may use calculator.
CASE STUDY – 1
Cooperative Farming:
Cooperative farming is a form of agricultural production which involves a group of farmers
pooling their resources, mainly their agricultural lands, and work together to achieve common
objectives. The members can share their knowledge and expertise and this form of performing
agricultural operations promotes efficiency, reduce costs, increase production and earnings.
The role played by these types of organisations is vital to the growth of rural communities by
supporting sustainable agricultural practices and providing greater economic opp ortunities.
Green Field Farmers Limited (GFFL):
Mr. Shreyas, who has more than ten years of experience in cooperative farming, owned fifty
acres of fertile agricultural lands in his hometown and he floated the idea of commencing a
venture in cooperative farming. The idea received positive response from the agriculturalists
situated nearby and soon he was able to gather around five hundred acres to be inducted into
cooperative farming, mainly to cultivate wheat. A company named Green Field Farmers
Limited (GFFL) was formed with an initial capital of ` 10 crores. Shares were allotted in the
proportion of each farmer's land holding. There were fifty shareholders and out of them seven
formed the Board of Directors. All the directors are entitled to a monthly remuneration of `
20,000 each. Mr. Shreyas is the Managing Director (MD). The main objectives of GFFL is to
provide reasonable and stable income and improve the social, economic well -being and the
overall quality of life of the shareholders.
Governance structure:
Any company in the long run can survive only if it has a strong Corporate Governance (CG)
which in turn would assist the company in improving the overall economic efficiency and bring
more stability.

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PAPER – 6A: RISK MANAGEMENT 3

The management of GFFL wishes to ensure that it operates in a democratic and transparent
manner by having clear policies in the matters of electing members to the Board, conducting

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meetings and decision-making process. Committees, advisory groups and working groups,

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which would support the various activities and operations, shall be formed to ensure that the

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interests of the stakeholders are well safe guarded.
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Proposal for Loan:
• GFFL principally decided to approach its Bankers for financing the purchase of 30 g
g a to be used for farming operations. The Bankers, in order to assign weightagesa
ltractors
a and thereby arrive at the score to decide whether to grant the loan or not, requested
GFFL to furnish various operating parameters along with its proposal for the loan. The
MD, in his personal capacity, is prepared to act as the Guarantor for the above loan.
• The management is aware that in case, if the wheat seeds for sowing are not timely
received from the supplier of such seeds, then consequently (i) that the cultivation of
wheat crops would come to a halt and (ii) thereby GFFL could not make loan repayments
to the Bank on a timely basis.

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. Officer (CFO) and the details of the same
Pilot Project:

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A Pilot Project was envisaged by the Chief Financial
are:
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Possible Event Cash Flow Probability
(` 000)
A 4,800 0.40
B 6,000 0.30
C 7,000 0.20
D 8,100 0.10

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. The first
Risk Management aspects of GFFL:

c. o • GFFL wants to have risk management principles to be meticulously followed.
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e functions, (ii)
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step in the process of risk management cycle is to identify (i) business

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(RM) identified the

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vulnerabilities and threats that GFFL might face, such as, (i) monsoon failures, (ii) yield
per acre reducing and (iii) depletion in soil fertility.
• The aim of the Chief Executive Officer (CEO) is that the Risk Management and Internal
Controls should be fully embedded into GFFL's operations and thereby enables GFFL to
convert the prevailing market uncertainties into opportunities.

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4 FINAL EXAMINATION: MAY, 2023

• The Board of Directors are having an apprehension· about the future performance of
GFFL. They posed the question to the RM that 'what challenges and uncertainties GFFL
is likely to encounter in pursuing its strategy, and what are the potential implications for
its business model and future performance? They wanted the RM to include his answer
to the question while presenting his Integrated Report (IR) that would contain discussion
under various Content Elements.
• The Board agreed to appoint a full-time internal auditor, Ms. Vidhya, who would be given
the task of periodically reviewing both the automated and manual controls in each of the
processes that have a direct bearing on the financials and overall operations of GFFL.
• During his study of international practice on risk identification and assessment
procedures, the MD came across a useful technique of risk identification, viz., "Cor porate
Knowledge" which would analyse the history of various risks.
• The Human Resources (HR) manager analysed the industry data available with him and
escalated a problem to the management that there might be delays in crop harvesting
due to acute labour shortage during the harvesting season, since the same set of farm
labourers have to service other farm owners also.
Based on the above, you are requested to answer the following questions:
Multiple Choice Questions
Choose the most appropriate answer from the given options -
(1.1) The possibility that the cultivation of wheat crops coming to a halt and its consequences
could also be called:
(A) Two Way Risk
(B) Risk Return Trade-off
(C) Default Risk
(D) Bank Guarantee Risk
(1.2) The MD's study of the risk identification technique which would analyse the history of
various risk to provide insight into future threats or opportunities through the following
except:
(A) Documented Knowledge
(B) Experiential Knowledge
(C) Lessons Learned
(D) Tacit Knowledge
(1.3) The aim of the CEO points out to which of the following risk maturity level?
(A) Risk Aware
(B) Risk Defined

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PAPER – 6A: RISK MANAGEMENT 5

(C) Risk Managed
(D) Risk Enabled

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(1.4) The Standard Deviation (rounded off to two digits) of the Pilot project as envisaged by

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the CFO is:

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(A) 1,080.56

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l(C)a 1,121.35
(B) 1,100.95

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(1.5) The RM while presenting his IR would answer the question of the Board under which of
following Content Elements?
(A) Business Model
(B) Performance
(C) Outlook

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(D) Strategy and Resource Allocation (2 x 5 = 10 Marks)

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. as part of their CG framework. Based on
Descriptive Questions

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e inputs which can be considered for disclosure
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(1.6) GFFL wishes to be transparent in its disclosures

a Governance Structure and (iii) Remuneration of
under (i) Objectives of GFFL, l(ii)
the information available, provide your

Directors. a g (3 Marks)
(1.7) You are required to suggest remedial measures to the vulnerabilities and threats
identified by the RM. (3 Marks)
(1.8) What parameters will the Bankers look for in the proposal for tractor loan of GFFL? As far
as the recovery risk of the tractor loan is concerned, how would the Banker consider the
same? (4 Marks)
(1.9) (i) What are the main purposes of the task proposed to be entrusted to Ms. Vidhya?

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(3 Marks)

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(ii) Write the Risk Factor and Key Risk Indicator in the problem escalated by the HR

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manager to the management. (2 Marks)

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Multiple Choice Questions
1.1 (A)
1.2 (D)
1.3 (D)
1.4 (B)

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6 FINAL EXAMINATION: MAY, 2023

1.5 (C)
Descriptive Questions
1.6 Disclosure as part of their Corporate Governance framework under:
(i) Objective: The main objective of GFFL is to provide reasonable and stable income
and improve the social, economic well-being and the overall quality of life of the
shareholders.
(ii) Governance Structure: Having clear policies in the matters of electing members to
the Board, conducting meetings and decision-making process. Committees,
advisory groups and working groups, which would support the various activities and
operations, shall be formed to ensure that the interests of the stakeholders are well
safe guarded.
(iii) Remuneration to Directors: A monthly remuneration of ` 20,000 to each director.
1.7 Remedial measures to the vulnerabilities and threats identified by the RM:
(i) Monsoon failures: As an alternate means of getting water, GFFL, a) may dig wells,
without affecting the eco system of the agricultural lands, b) Rain -water harvesting
may be done and c) drip and sprinkler irrigation methods may be followed.
(ii) Yield per acre reducing: a) To follow scientific methods of farming to increase the
yield, b) May resort to crop insurance
(iii) Depletion in soil fertility: a) usage of organic manure to maintain the soil fertility,
b) rotation of crops and c) applying right ratio of nutrient requirement by making
scientific soil study.
1.8 The Bankers will look for the following parameters in respect of the tractor loan proposal
of GFFL:
(i) soil fertility, ii) area under cultivation, iii) produce per acre, iv) rainfall / reservoirs
levels, v) make and model of the tractor.
Recovery Risk is related to recoveries in the event of default, by GFFL, which in
turn depends upon various factors such as quality of guarantee provided by GFFL,
and other surrounding circumstances. This risk can be reduced through Collateral
and Third-Party Guarantee.
Third party Guarantee Risk: The MD, in his personal capacity, is prepared to act as
the Guarantor for the above loan. The collateral is a kind of simple transfer of risk
on Guarantor and if the guarantor defaults, then the risk again comes back to
lender.
1.9 (i) The main purposes of task entrusted to Ms. Vidhya, the internal auditor:
A review of control is to be done regarding:
• appropriateness of the purpose of the control and its correlation to the
risk/assertion.

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PAPER – 6A: RISK MANAGEMENT 7

• appropriateness of control considering the nature and significance of the risk.
• Competence of authority performing the control (especially if it is of a nature of
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supervisory review);

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•
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Frequency and consistency with which the review control is performed,

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including clarity of the exact steps of performance of the review control.
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l(i)a Periodically reviewing both the automated and manual controls in each of thea
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GFFL.
(ii) Risk Factor and Key Risk Indicator in the problem escalated by the HR manager:
Risk Factor: Delays in crop harvesting
Key Risk Indicator: Acute labour shortage during the harvesting season.
CASE STUDY– 2

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The Company and its project

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Aero Manufacturing Limited (AML) is a company presently engaged in manufacturing

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electronics parts for aircrafts and runs the project PUMA. The project PUMA is a passenger

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aircraft program and it is likely to reach the implementation stage soon. It is going to be India's

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first aircraft manufacturing Company. The Company is expecting its new project will be a

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game changer and would be in alignment with the growth story of the Indian aviation sector.
This project has necessitated entering into agreements with more than 100 vendors. Most of
the vendors have a long standing relationship with AML.
Before this project was started, the Company gained extensive experience in aircraft
manufacturing as a trusted partner of a leading public sector company that manufactures
combat aircraft and has been a preferred vendor for aircraft manufacturers in France and the
USA. Approximately 40% of the revenue is from export and 30% of procurement like chips etc.
is imported.

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Risk management at AML

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As the Company is deeply involved in innovation there is less focus on aligning risk with the

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strategy. The Chief Executive Officer (CEO) believes that this is necessary for the Company

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as it allows flexibility which is necessary for innovation. He also backs his proposition based

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on past success. However, there are few directors who have a different view and they differ

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from the view of the CEO.
During risk assessment procedures, AML discovered that appropriate security clauses around
sensitive information related to the project PUMA have not been incorporated appropriately
into the vendor contract. The legal team of AML and the procurement head is of the opinion
that this is common practice and should not be worried as the cost of implementation of
security protocol will make the contract costlier. When the vendor was requested to assess the

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8 FINAL EXAMINATION: MAY, 2023

contract cost impacts of incorporating the new security protocols, the cost was more than AML
could bear. AML now has two options:
(i) Give a waiver to the vendors or
(ii) Negotiate with prime vendors to meet the intent of the levied security protocols to ensure
the protection of sensitive information while maintaining the cost impacts within
budgetary constraints.
On a review, it is evident that a waiver would have an irreparable impact and leave much
sensitive information vulnerable to theft or misuse. The positive point is that the vendors are
long-standing partners of AML. One of the consultants has suggested that training to vendor's
workforce can minimise the cost to implement a new security protocol. Not everyone is
convinced by this idea and the matter is unresolved even though there is an agreement to find
a solution to this burning problem.
Further, the Board is aware that defining and applying risk appetite is one of the more
challenging risk principles. Also, there is no formal process for the identification and
measurement of key risk indicators (KRls) and associated risk tolerance ranges in AML.
Despite dissent by a few directors, the majority of directors have decided to rope in a leading
consultant in this area so that a comprehensive and complete risk appetite statement for AML
can be developed.
Treasury operations by AML
The treasury of AML has been managing forex risk on a regular basis using currency options
and currency futures. In very few instances currency forwards have been used as the head of
the treasury believes that the forward currency contract market lacks liquidity in India. The
financial performance has been spectacular during the last decade.
Mr. Rakshit has recently joined the bank with which AML is dealing and has been asked to
handle spot currency transactions related to AML. He has been given access to the Reuter
Screen. The following quotes are available on the Reuter Screen:

USD/INR 84.3245 / 46
USD/GBP 1.1298 / 02

In addition to the above the treasury has taken a long position in USD/INR call option. It is
desired that a more detailed analysis is done on currency option positions in terms of delta,
Vega, gamma, and theta. The Treasury has been using Black-Scholes Option Pricing Model
(BSOPM) instead of the Binomial Trial Model for the valuation of interest rate derivatives. The
auditors have raised concerns about the same.

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PAPER – 6A: RISK MANAGEMENT 9

Multiple Choice Questions
Choose the most appropriate answer from the given options.

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(2.1) Which one of the following is correct regarding the statement that the forward currency

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market lacks liquidity in India?

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(A) Forward contracts generally result in losses in import transactions in India as USD

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has been regularly appreciated.
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(B) Forward contracts cannot be converted into cash.

(D) Forward contracts are less preferred hedging instruments.
(2.2) Assuming AML has called Mr. Rakshit and asked him to sell INR, what rate he will quote
to AML?
(A) INR 84.3245
(B) INR 84.3246

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(C) INR 84.3201

(2.3) Assuming AML has called Mr. Rakshit e masked him to sell GBP, what rate he will quote
(D) INR 84.4546

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to AML?
(A) GBP 1.1298 a
(B) GBP 1.1202
(C) GBP 1.1302
(D) GBP 1.0298
(2.4) Which of the following is incorrect with respect to the alignment of risk with strategy?
(A) Alignment of risk with strategy is right.

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(B) Alignment of risk with strategy is a combination of setting strategy, managing

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performance, and managing risk.

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(D) Alignment of risk with a strategy does not work in the case of companies

l a (2.5) Which of the following is correct when the interest rate of baseacurrency increases in the
innovative products.

ag case of the USD/INR call option?
(A) Call option price will go down.
(B) Call option price will go up.
(C) There will be no change in the call option price.

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10 FINAL EXAMINATION: MAY, 2023

(D) Only the volatility of the call option will change. (2 x 5 = 10 Marks)
Descriptive Questions
(2.6) (A) Do you think AML should have built-in IT security in the vendor agreements? Which
option you would recommend to address the problem related to the non -inclusion of
security clauses in the Vendor Agreement executed by AML? Give a reasoned
answer. (2 Marks)
(B) If training at the vendor site would reduce cost, what are the broad aspects you can
identify that need to be included in the training program? (3 Marks)
(2.7) (A) Do you agree with the view that defining and applying risk appetite is one of the
more challenging risk principles? Give a reasoned answer. (2 Marks)
(B) Before finalising the risk appetite statement what key factors AML should consider?
(2 Marks)
(2.8) Explain the limitations of BSOPM when applied to the valuation of interest rate
derivatives.
(3 Marks)
(2.9) Briefly explain the derivatives which can be used by AML to hedge its currency risk.
(3 Marks)
Answer
Multiple Choice Questions
2.1 (C)
2.2 (A)
2.3 (A) or (C)
2.4 (D)
2.5 (B)
Descriptive Questions
2.6 (A) Yes. AML should have built-in IT security in the vendor agreements.
IT security is critical to AML. IT security needs to be built into vendor agreements to
reduce operational risks considering the criticality of the project PUMA. Ideally, it
should have been incorporated at the time of entering into the contract. If such
clauses have not been factored into existing contracts, it would be worthwhile to
subsequently incorporate these clauses into the contracts and rationalise the
incremental cost structure by working with the vendor.
Option 2 i.e. negotiation with prime vendors needs to be considered as sensitive
information related to the PUMA Project needs to be protected for long -term value
creation. This is also backed by the past relationship of the vendor. It should be
possible to work with it to find a solution. The way forward should be to work closely

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PAPER – 6A: RISK MANAGEMENT 11

to identify the security requirements and reduce risk to the largest extent and
identify how these requirements could be levied on the prime vendors with minimal

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cost impact from wording or process changes.

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(B) Training the team at the vendor site could be a possible solution and is likely to

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decrease the cost. This will help the vendor team to fully understand and implement

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e(i) How to identify and categorise sensitive information
the new security protocols. The training may typically involve:

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(iv) How to store information
(v) What should be the protocol for the transmission of information
(vi) What should be the possible administrative action and criminal prosecution
2.7 (A) Yes, as there is no set standard that fits all entities.
Further, defining risk appetite and preparing a risk appetite statement requires

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consideration of both qualitative and quantitative measures, which is generally

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challenging because qualitative characteristics are often difficult to measure and

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monitor. To make it more effective consideration is needed to align risk appetite to

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the risk culture and decision-making environment.

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(B) Before finalizing the risk appetite statement, it would be helpful for AML to identify
the key risk indicators (KRIs) relevant to measuring and monitoring risk and t o
establish risk tolerance ranges for the identified KRIs. This process can help inform
the language used to describe the risk and related risk appetite. Moreover, regular
reporting of KRIs with the associated risk tolerance can help the AML monitor
whether it is operating within its targeted risk profile and whether it can ultimately
achieve its strategic and business objectives.
2.8 (i) In the BSOPM the risk-free interest rate is kept constant. The interest rate
derivatives are predicated on likely changes in interest rates.

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(ii) Volatility or standard deviation is kept constant in BSOPM. The volatility of a bond

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varies over its maturity period.

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(iii) The underlying for BSOPM is typically share which is an asset whereas

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rates are not assets.
(iv) The BSOPM is applicable for the European style option g
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2.9 AML can use following derivatives to hedge its currency risk:
(i) Forward Contract: The simplest form of derivatives is the forward contract. It obliges
one party to buy, and the other to sell, a specified quantity of a nominated
underlying financial instrument at a specific price, on a specified date in the future.

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12 FINAL EXAMINATION: MAY, 2023

(ii) Future Contract: Though very similar to the forward contract in its obligation and
payoff profile but its contract terms are standardized in terms of Quantity and
Quality of the underlying, time and place of delivery and settlement.
(iii) Option Contract: An option is a contract which has one or other of two key
attributes:
• to buy (call option)
• or to sell (put option)
The purchaser is called the buyer or holder; the seller is called the writer or grantor.
The premium may be expressed as a percentage of the price per unit of the
underlying.
(iv) Swaps: A swap transaction commits the participants to exchange cash flows at
specified intervals, which are called payment or settlement dates. Cash flows are
either fixed or calculated for specific dates by multiplying the quantity of the
underlying by specified reference rates or prices.
CASE STUDY – 3
Introduction of the company named TQM
Over the past decade, TQM had grown rapidly through acquisition, snapping up more than 30
firms and creating a highly complex conglomerate in the process. By 2022, TQM had become
one of India's largest and the most diverse companies, covering a wide variety of businesses
that include, inter alia, chemical, sugar, automotive tyres, electronic, medical instruments,
media, and FMCG.
While most consumers are unfamiliar with the TQM name but its brands are well-known
among businesses and consumers. TQM was structured into seven business segments, each
of which is bigger than most of their competitors' entire companies.
Issues identified in TQM
• Along with the high growth path various risks have magnified over the period. In one
instance in the Tyre Segment, a particular lot of sizable quantity was recalled for faulty
production. Following this incident revenue went down significantly. However, the
replacement of tyres and communication with the customers helped the Company in
gaining lost ground.
• Various risks like strategic, reputational, credit, market, liquidity, interest, legal,
regulatory, etc., have been rising. No independent review has taken place in order to
bring a new perspective to risk management.
• Managing business risks and financial risks is the top priority of the management going
forward. There are some processes for managing financial risks but there are no formal

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PAPER – 6A: RISK MANAGEMENT 13

methods used to manage business risks. In the absence of a structured process for risk
management, the Board wants a clear roadmap for integrated risk management.

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• Mr. Rowan, who is head of the treasury, is confident that his team will be able to identify

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risks that can be clubbed under business risk and financial risk categories and would be

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able to design a system that would help in the effective management of the same. For
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better clarity, he will also prepare a list of controllable and uncontrollable risks so that

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• g TQM has a very liberal credit policy in relation to customers which is reflected in risinga
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effective steps are taken to manage them if found inadequate on review.
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a receivables days over the period and also substantial jumps in bad debts in a major
segment of the business. This also has created a liquidity problem for the Company.
• The surplus cash has been invested in a mix of equity and long-term debt instrument to
generate more return. In addition to this, the Company has. made investments in five
private equity firms. The Company regularly receives data on the performance of private
equity investment along with Value-at-Risk (VaR) data. One of the juniors has made an
effort to compare the VaR data of five private equity firms but could not do so as each

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private equity firm has a different time horizon and asset mix and uses different
confidence levels.

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so is the cost of compliances. In fact,sthere have been instances of payment of fines that
• The compliances have gone up significantly

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were imposed by the regulatorygauthorities.
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managers shift the blame to internal
• Sometimes the Board also gets confused regarding the responsibility of operational risk
management and internal audit.
• In addition to the above, TQM has used significant debt amount for funding acquisitions
and uses various interest rate derivatives like Interest Rate Swaps (IRS), Forward Rate
Agreement (FRA), CAPs, Floors, Swaptions and Credit Default Swap (CDS) for

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hedging/restructuring existing and future debt. The Company has developed an in-house

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skill set to deal with such derivative products. But there is a problem of staff attrition,

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especially in the treasury area. Past data shows that the Company has become a training

em se
ground for treasury operations. To some extent, it helps in building a reputation but it

s g la
also involves costs in training junior professionals. The Company has decided to prepare

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a structured training manual so that cost of training can be minimized. You, being an

a
expert in financial derivatives, have been hired to prepare a training manual.
Future business plans
• The Board has agreed to support the management to identify new business
opportunities. Following this direction, the management has ventured into the natural gas
discovery business. The Chief Finance Officer (CFO) expects to borrow USD 20 million

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14 FINAL EXAMINATION: MAY, 2023

in one year's time to finance a new offshore drilling platform, and will need the funds for a
period of one year. The current market interest rate is 5%. The treasury team expects
that the rate will rise to 6.00 % by the time TQM needs the money. The treasury team
has decided to lock in the 5.00% rate and accordingly has entered a 12 x 24 FRA at 5.00
per cent with a foreign bank, where the reference rate is the LIBOR.
Multiple Choice Questions
Choose the most appropriate answer from the given options.
(3.1) Which of the following is incorrect with respect to an IRS?
(A) IRS has two major sources of risks namely market risk and credit risk.
(B) Interest rate affects both fixed and floating sides of the swap in a similar manner.
(C) Interest rate affects both fixed and floating sides of the swap differently.
(D) Credit exposure changes over the life of an IRS.
(3.2) The sources of risk in capital budgeting, depend on the type of investment being
considered. These sources do not include:
(A) Project specific risk
(B) Company specific risk
(C) Industry specific risk
(D) Governance specific risk
(3.3) Which of the following is incorrect with respect to CDS?
(A) In CDS protection buyer pays periodic payments (premium) to the protection seller.
(B) Protection seller pays par value to the protection buyer in case of default on the
reference obligation and the protection buyer delivers the defaulted reference
obligation.
(C) There are two basic settlement methods: cash settlement and physical settlement.
(D) Protection seller only pays par value to the protection buyer in case of default on
the reference obligation.
(3.4) Which of the following is correct with respect to controllable risks?
(A) Controllable risks need to be prevented always.
(B) Attrition of people is one of the internal factors of controllable risks.
(C) Natural calamities are external factors of controllable risks.
(D) Controllable risks need not necessarily be prevented but the financial loss can be
minimised.
(3.5) Which of the following is correct with respect to uncontrollable risk?
(A) Contingency plan has no role in addressing uncontrollable risks.

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PAPER – 6A: RISK MANAGEMENT 15

(B) Technological changes are not a factor of uncontrollable risk.
(C) Compliance with regulatory changes is an example of uncontrollable risk.

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(D) Recessionary economy is an example of uncontrollable risk. (2 x 5 = 10 Marks)

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Descriptive Questions

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e (3 Marks) la
(3.6) Do you think credit risk in IRS is the same as that in bonds? Give your reasoned answer.

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(3.7)lAnswer a g
ag (A) The settlement amount of FRA will depend on which date and which period LIBOR?
the following questions based on the information given for FRA

(1 Mark)
(B) Assuming that the 12m LIBOR has risen to 6% on the reference date TQM will
receive or pay and what would be the amount assuming 365 days count
convention? (2 Marks)
(3.8) (A) Identify and list four key financial risks and business risks being faced by TQM.

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(2 Marks)

c. o
(B) Based on the information given in the Case Study, identify two prominent credit

emuniformly across private equity firms? Give a
risks being faced by TQM? (1 Mark)

la s
(3.9) In your opinion can the VaR be applied
reasoned answer.
(3.10) Few Board members of TQM
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a are confused with responsibilities related to operational
(2 Marks)

risk management. Do you think internal audit is part of operational risk management?
Give a reasoned answer. (2 Marks)
(3.11) What are the analysis and investigation models you would like to suggest to the
management of TQM for assessing business risks? (2 Marks)
Answer
Multiple Choice Questions
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3.1 (B)

c. o 3.3 (D) se
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l a 3.4 (D)
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ag 3.5 (D)
Descriptive Questions
3.6 Credit risk in IRS is not the same as in bonds.
Though both IRS and Bonds are exposed to Credit Risk but following are some major
differences.

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16 FINAL EXAMINATION: MAY, 2023

(i) Nature: - While in IRS the counter party can default in payment of interest amount.
In Bond this default can on be both account interest and as well as Principal.
(ii) Structure: - While an IRS is a bilateral agreement between two parties in Bond
there is one issuer and multiple holders.
(iii) Exposure: - In IRS risk limited to PV of net future cash flows. In Bond it is usually
full amount of Bond.
Or
Credit risk in IRS is not the same as in bonds.
In fact, it differs from bonds. In the IRS the principal is notional on which interest is
calculated. This means the principal is never exchanged. Therefore, unlike bonds, there
is no principal risk in IRS. Also, when the current value of an IRS is negative there is no
loss from the IRS being terminated on account of counterparty default and he nce there is
no credit risk concern. Only in case the value of the IRS is positive credit risk exists.
3.7 (A) The settlement amount of the FRA will depend on the 12 months LIBOR in 12
months.
Or
Interest Rate after 12 months for a period of 12 months.
(B) Final settlement amount shall be computed by using formula:
(N)(RR- FR)(dtm/DY)
=
[1 + RR(dtm/DY)]
Where,
N = the notional principal amount of the agreement;
RR = Reference Rate for the maturity specified by the contract prevailing on the
contract settlement date;
FR = Agreed-upon Forward Rate; and
dtm =maturity of the forward rate, specified in days (FRA Days)
DY = Day count basis applicable to money market transactions which could be 360
or 365 days.
Accordingly,
If actual rate of interest after 12 months happens to be 6%
(USD 20 Million)(0.06- 0.05)(365/365)
=
[1 + 0.06(365/365)]
(USD 20Million)(0.01)
= = USD 1,88,679 or USD 0.18867 Million
1.06
Thus, foreign bank will pay TQM a sum of USD 1,88,679 or USD 0.18867 Million.

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PAPER – 6A: RISK MANAGEMENT 17

Or
Bank of TQM will pay TQM on the start date.

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Settlement amount = 20,000,000 x (6% - 5%) / (1 + 0.06) = USD 1,88,679

.co e m
3.8 (A) Four key financial risks faced by TQM are Credit Risk, Market Risk, Liquidity Risk

m a s
and Interest Rate risks.

s eFour g l
la a
key business risks faced by TQM are Legal Risk, Regulatory Risk, Strategic

ag (B) Two prominent credit risks faced by TQM are as follows:
Risk and Reputational Risk.

(i) Rising receivable days over the period.
(ii) Substantial jumps in bad debts in a major segment of the business.
(iii) Counterparty risk in derivative transactions.
3.9 No, VAR cannot be uniformly applied across private equity firms because of the following
reasons:

m
(i) Unique Characteristic of Investment: – Generally Private Equity investments are

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often characterised by their unique nature and hence lack standardization.
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(ii) Longer Period of Investment: – PE investments generally have a longer period and

a s
are quite illiquid in nature. Hence, application of VAR is bit difficult.

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(iii) Assumptions: – Unlike publicly traded financial assets in valuation of PE
a
investments a lot of additional assumptions are required to be made.
(iv) Lack of Sufficient Historical Data: – Contrary to traditional financial instruments
there is a dearth of historical data for PE investments.
Or
No, VAR cannot be uniformly applied across private equity firms.
Each private equity firm will have different time horizons, confidence levels, and
measuring periods and hence VaR cannot be applied consistently across private equity

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firms. VaR is not additive. It is a measure of the probability that is dependent upon firm’s

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time horizon, specified confidence levels, and asset mixes. VaR measures vary widely

c. o 3.10 Internal audit should not be confused with the responsibilities related stoeoperational
across equity firms.

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management. Internal Audit is an independent third line of defense which is different from

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the first (business) and second (risk management) line of defense. But internal audit is
responsible for auditing the second line (risk management), but that does not mean that it
will also be a part of risk management.
Or
Yes, Internal Audit is part of Operational Risk Management as it is covered under the 3rd
line of defense. Further an effective internal audit would highlight issues and potential

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18 FINAL EXAMINATION: MAY, 2023

gaps in processes, which were missed by the first two lines of defense as well. As an
independent vertical, their value addition provides a better insight into the pr ocess from a
holistic perspective since they are not directly involved in managing the process.
3.11 For assessing business risks, TQM can use following models:
(i) SWOT analysis (Strengths, Weaknesses, Opportunities and Threats)
(ii) PESTLE Analysis where P denotes for Political, E for Economic, S for Social, T for
Technological, L for Legal and E for Environmental.
The above models will be useful for assessing competitor positions, business strategies,
plans, industry and market.
CASE STUDY – 4
The Company:
Universal Traders Limited (UTL) is engaged in procuring, marketing, and distributing
Consumer Packaged Goods (CPG). Their product range includes packaged foods and
beverages, cosmetics, toiletries etc., consumed mainly by household consumers. UTL ha s
retail outlets throughout the State of Tamil Nadu.
Availability of products:
The number of products consumed are increasing day by day as well as the customers' needs.
The tendency of the present-day customer is to get the products immediately, the moment
they are shown in a television advertisement or other online media. Either the consumer would
visit a store to get them, or they would resort to online buying. Even a product that is available
in the market for a long time, consumers prefer to buy it online. This has placed a tremendous
challenge to companies like UTL. Timely availability, coupled with competitive pricing are the
main remedies to the challenge.
Supply Chain Risk Management:
It is all the more necessary for UTL to revisit the aspects of Supply chain mechanism and to
strengthen the same and the management realised the need to study and assess the Supply
Chain Risk Management. It is the process of identifying, assessing, and evaluating and taking
mitigation efforts to counter the risks which have the propensity to impact the delivery of
goods and services in a supply chain process.
Natural disasters, political unrests, labour problems, breakdown of transport vehicles etc., are
some common risks which could impact supply chains. It is imperative to maintain and
meticulously follow proper policies and procedures for all the processes followed. Constant
and proactive lookout is necessary to address the gaps in the processes besides continuous
monitoring mechanism of the control structure. The presence of any weakness could
undermine the entire supply chain.

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PAPER – 6A: RISK MANAGEMENT 19

Loan for Expansion:
The Managing Director (MD) requested the Chief Financial Officer (CFO), Ms. Tiya, to study
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the various aspects of expansion of the present operations of UTL. After completing the task,

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Ms. Tiya arrived at a figure of ` 7 Crores which might be needed for the expansion. She felt

.
that the same may be obtained as a long-term loan from its banker, ABC Bank Limited
m s e
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(ABCBL). Ms. Tiya approached ABCBL and negotiated the interest rates and other charges on

l a
the loan. Ms. Tiya was insistent for reduction in interest rates and other charges and the
a g
ag
negotiations are taking longer time with ABCBL. In this scenario, ABCBL concluded that there
is possibility that the pay off by UTL will be late.
Challenges faced:
• In order to ensure the continuity of the business of UTL, the Risk Manager, Mr. Das, after
studying the occurrence of stress scenarios of similar companies in the industry,
concluded that such stress scenarios happened in the industry once or twice in a ten-
year time period.
• The Operations Manager, Mr. Raj, narrated a few problems found with some of their staff
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to the Human Resources (HR) Manager, such as, not having sufficient experience as
required by the job required to be performed, indulging in theft of materials from the

em
warehouse of the company and not being punctual in attending work on many days.

a s
l on the right kind of tool to employ, in order to
• UTL is having an investment portfolio totalling to ` 5 Crores. Ms. Tiya and the Chief

ag Ms. Tiya is opting for using Value at Risk (VaR)
Executive Officer (CEO) were discussing
optimise the return on investments,
methods, whereas the CEO advocated for employing Coherent Risk Measures to achieve
the results. Ms. Tiya clarified to the CEO that as far as UTL 's transactions are
concerned, VaR would be a better option. Ms. Tiya explained the few drawbacks of VaR
to the CEO to be borne in mind.
• UTL is considering hedging the interest rate risk. It wants to follow the traditional method
for the same. The finance manager was asked to suggest such a suitable method.

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• The IT Manager, Mr. Suresh, is given the exercise of conducting a risk evaluation for the
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project of revamping the existing information system (IS) of UTL. With regard to the

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above project, Mr. Suresh comes out with the following proposal:
Total risk of failurea
s (in %) g
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Investment in IS

g
` (in crores)
a
a Original Investment 5 30
Additional Investment 2 20

• The Logistics Manager, Mr. Pavan, is considering the possibility of outsourcing the
logistics operations. He believes that if such functions are contracted out, UTL can

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20 FINAL EXAMINATION: MAY, 2023

attribute the delay in deliveries to the logistics operator and thereby make them
responsible and avoid negative publicity to UTL.
Audit of Transactions:
An auditor, Mr. Arvind was appointed to go through the past two years' transactions. He was
very much careful in selecting the transactions for testing as well as applying the audit
procedures, as they may be subject to sampling as well as non-sampling risk. He conducted a
test of controls on the transactions by applying sampling techniques and found out few errors
and omissions. He informed the management that these errors and omissions cou ld have
been avoided, had there been strong internal controls.
Other Information:
In respect of a transaction involving foreign exchange, the Accountant, Mr. Gupta, gathered
the following information from ABCBL.
On Sep 05, 2022, the Bank quotes the following:
Spot exchange Rate (US $ 1) 79.2221 79.5258
INR
2 months' swap points 60 80
3 months' swap points 150 178

In a spot transaction, delivery is made after 5 days.
Based on the above, you are requested to answer the following questions:
Multiple Choice Questions
Choose the most appropriate answer from the given options.
(4.1) Which one of the following is not true about a non-sampling risk in the audit conducted by
Mr. Arvind?
(A) Non-sampling risk includes the possibility of selecting audit procedures that are not
appropriate to achieve the specific objective.
(B) Non-sampling risk varies inversely with sample size, the smaller the sample size,
the greater the non-sampling risk.
(C) Non-sampling risk arises because the auditor may fail to recognize misstatements
included in documents that he examines, which would make that procedure
ineffective even if he were to examine all items.
(D) Non-sampling risk can be reduced through such factors as adequate planning and
supervision.

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PAPER – 6A: RISK MANAGEMENT 21

(4.2) Which one of the following statements is true with respect to the consideration of
Mr. Pavan?

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(A) UTL's exposure may be tolerable without any further action being taken.

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(B) It is generally not possible to transfer reputation risk even if logis tics operations are
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outsourced.
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(C) The risks are containable to acceptable levels by terminating the activity itself.

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a(4.3)g The
(D) Action is taken to contain the risk of outsourcing to an acceptable level.
conclusion of ABCBL is based on which of the following ground rules of credit risk
assessment followed by ABCBL?
(A) Recovery
(B) Due Diligence
(C) Check the Credibility
(D) Understand the Reality

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(4.4) Which of the following method of hedging of interest rate risk, the finance manager would

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suggest?

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(A) Forward Rate Agreement
(B) Interest Rate Futures

l a s
(C) Cap Option
(D) Basis Rate Swap a g
(4.5) The study of Mr. Das would make him conclude that the stress scenarios of similar type
of companies in the industry would be categorised under:
(A) Severe stress scenario
(B) Near default stress scenario
(C) Normal stress scenario

o m
(D) Reverse stress test scenario (2 x 5 = 10 Marks)

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. you to:
c. o (4.6) In respect of the transaction involving foreign exchange, Mr. Gupta hassrequested
Descriptive Questions

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(i) ascertain swap points for 2 months and 15 days. (For 25 Nov, 2022)

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(ii) determine foreign exchange rate for 25 Nov, 2022, and
(iii) compute the annual rate of premium/discount of US$ on INR, on an average rate.
Assume spot date as Sep 10, 2022
Assume 1 swap point = 0.0001 (3 Marks)
(4.7) Write a brief note on Mitigating Controls. Suggest mitigating controls for the problems
narrated by Mr. Raj to the HR Manager. (3 Marks)

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22 FINAL EXAMINATION: MAY, 2023

(4.8) What are the drawbacks as explained to the CEO by Ms. Tiya? (4 Marks)
(4.9) (i) What is purpose of Mr. Suresh's exercise? Do you agree with his proposal of
making additional investment in IS? Show your workings. (3 Marks)
(ii) Discuss the relationship between Control Effectiveness and Residual Risks. (2 Marks)
Answer
Multiple Choice Questions
4.1 (B)
4.2 (B)
4.3 (D)
4.4 (A)
4.5 (C)
Descriptive Questions
4.6 (i) Swap Points for 2 months and 15 days
Bid Ask
Swap Points for 2 months (a) 60 80
Swap Points for 3 months (b) 150 178
Swap Points for 30 days (c) = (b) – (a) 90 98
Swap Points for 15 days (d) = (c)/2 45 49
Swap Points for 2 months & 15 days (e) = (a) + (d) 105 129

(ii) Foreign Exchange Rates for 25 th November 2022
Bid Ask
Spot Rate (a) 79.2221 79.5258
Swap Points for 2 months & 15 days (b) 0.0105 0.0129
79.2326 79.5387

(iii) Annual Rate of Premium
Bid Ask
Spot Rate (a) 79.2221 79.5258
Foreign Exchange Rates for 79.2326 79.5387
25th November 2022 (b)
Premium (c) 0.0105 0.0129
Total (d) = (a) + (b) 158.4547 159.0645

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PAPER – 6A: RISK MANAGEMENT 23

Average (d) / 2 79.2274 79.5323
Premium 0.0105 12 0.0129 12
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× × 100 × × 100

c. o
79.2274 2.5 79.5323 2.5
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= 0.0636% = 0.0778%

m controls: They refer to procedures, methods and other measures which are put las
or 0.064% or 0.078%
e
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inaplace to lessen the risk or the impact of a certain threat or vulnerability.
4.7 Mitigating
g
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ag From the problems by narrated by Mr. Raj, it can be said that the company is facing
Staffing Risk.
Mitigating controls suggested to address the staffing risk:
(i) employing the right person for the right job, ii) well drafted job descriptions, iii)
thorough background verifications and iv) employing experienced personnel are the
some of the mitigating controls.
Or

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Mitigating Controls are activities that are intended to prevent the inherent risk fr om

.
materialising into a real failure of the process / transaction. These activities are designed

em
keeping in mind the overall process objective, the inherent risks in the process, and the

a s
impact of the risk if the failure were to materialise in reality.

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For the problems narrated by Mr. Raj to the HR Manager following mitigating controls are
suggested: -
(i) Preventive Controls: – Proper appointment of staff having requisite qualification
and experience.
(ii) Detective Controls: – To control theft, intensive processes of verification and
authorization are required to be built in.
(iii) Automated Controls: – To ensure punctuality of attendance, Automated Control
such as punching machines can be installed.

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4.8 The drawbacks of VaR as explained to CEO by Ms. Tiya:

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(a) VaR uninformative of tail losses – VaR tells us the most we can lose if a tail event

se
does not occur. It tells us the most we can lose 95% of the time but tells us nothing

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about what we can lose on the remaining 5% of the occasions. If a tail event (i.e.

las a g
loss in excess of VaR) does occur, we can expect to lose more than the VaR but

g
VaR itself does not give any indication of how much that might be.

a (b) VaR can create perverse Incentives Structures – It is not feasible to use information
about VaR at multiple confidence levels and where it is not, the failure of VaR to
take account of losses in excess of itself can create some perverse outcomes. For
example, an investor using a VaR risk measure can easily end up with perverse
positions because a VaR based risk return analysis fails to take account of the
magnitude of the losses in excess of VaR. If a particular investment has a higher

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24 FINAL EXAMINATION: MAY, 2023

expected return at the expense of the possibility of a higher loss, a VaR based
decision will suggest that we should make that investment if the higher loss does
not affect the VaR regardless of the size of the higher expected return and the size
of higher expected loss. Such acceptance of any investment that increases
expected return regardless of the possible loss and the investor who makes
decisions in this way is asking for trouble.
(c) VaR can discourage diversification – Another drawback is that VaR can discourage
diversification. The VaR of the diversified portfolio is much larger than the VaR of
the undiversified one. So, a VaR measure can discourage diversification of risks
because it fails to take into account the magnitude of losses in excess of VaR.
(d) VaR not sub-additive – Sub–additivity means that aggregating individual risks does
not increase overall risk. Sub-additivity matters for a number of reasons. If the risks
are sub-additive then adding risks together would give us an overestimate of
combined risk. This facilitates decentralised decision making within a firm as we can
always use the sum of the risks of the units as a conservative measure. But if the
risks are not sub-additive, adding them together gives us an underestimate of
combined risks, and this makes the sum of risks effectively useless as a risk
measure. In risk management, we want our risk estimates to be biased or unbiased
conservatively.
4.9 (i) The purpose of the risk evaluation is to identify the inherent risk of performing
various business functions especially with regard to usage of information technology
enabled services.
The purpose of a risk evaluation exercise for the project of revamping the existing
information system (IS) of the company:
• Identify the probabilities of failures and threats,
• Calculate the exposure, i.e., the damage or loss to assets,
• Make control recommendations keeping the cost-benefit analysis in mind.
Savings in making additional investments:
Investment in IS Total risk of Exposure
` (in Crores) failure ` (in Crores)
Original Investment ` 5 Crores 30% 1.5
(` 5 Cr × 30%)
Additional Investment ` 2 Crores 20% 1.4
(` 7 Cr × 20%)
Thus, there is a saving of ` 10 lakhs (` 1.5 Cr – ` 1.4 Cr).
Therefore, I agree to the proposal of Mr. Suresh.

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PAPER – 6A: RISK MANAGEMENT 25

(ii) Relationship between Control Effectiveness and Residual Risks:
The higher the control effectiveness, the lower the residual risk.

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Lower the control effectiveness, the residual risk would be same or similar to level

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of inherent risk.

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CASE STUDY - 5

s e g l
la Pharma Limited (DPL), is a pharmaceutical company established in Pune and havinga
About the company

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aan overall turnover of ` 2,400 Crores in the financial year 2021-22. It is a listed company in
Dynamic

India and in the United States of America. DPL has eight manufacturing f acilities in various
locations in India and four manufacturing facilities outside India.
Out of DPL's total revenue, exports to USA constitute 70%. Since DPL's major market is in the
USA, it had to obtain approvals from Food & Drug Administration (FDA) before it manufactures
or markets any of its drugs in USA. Due to the incidence of COVID-19, the Company's
applications for approval of new drugs were pending with the FDA for a long period of time, on

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account of which the Company is unable to launch new products in USA in recent past.

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The company has a Risk Management Function headed by its Chief Risk Officer. The function

s
has a team of twenty five people working for all the functions/businesses in an ERM centric

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environment. The ERM team works independently and the ownership of implementation of

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Risk management is with the risk management team.
Expansion plans of the company
During the financial year 2021-22, DPL procured Active Pharmaceutical Ingredient (APls)
aggregating to ` 750 Crores by importing from European countries where payments were
made in USD. These APIs are predominantly used in the generic medicines for treating
patients affected with Oncology, Immunology, Anti-diabetics etc.
As a strategic move, DPL's board has suggested to setup an API plant in Cyprus to
manufacture & reduce the imports to India from European suppliers. The management team
has also evaluated the associated Country and Political risks.
o m
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c. o 1. Free trade agreement between India and Cyprus is in force, wherein sallethem.API imports
The following benefits were noticed:

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from Cyprus attracts Nil import duty, whereas imports from European countries attracts

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16% duty.
2. Cyprus government has extended the following benefits to the project:
• Leasehold land in an industrial zone for 25 years.
• Contract labour upto 1500 labourers can be engaged at the Unit.
• Uninterrupted supply of water & electricity.

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26 FINAL EXAMINATION: MAY, 2023

• Permission to have bank accounts outside of Cyprus and no restrictions on
repatriation of Funds.
However, the following obligations to be complied by DPL were also identified:
(1) Labour and environmental laws to be followed.
(2) Local suppliers to be used.
(3) Insurance cover to be sourced from local insurance companies
(4) Create employment opportunities in Cyprus and
(5) Expats strength should not increase above 400 at the Unit.
Issues emerged at Cyprus
Based on the approvals, the management team has initiated the capex projects of setting up
the API manufacturing facility in Cyprus. Six months after the start of these major capex
projects in Cyprus, the company started receiving multiple whistle blower complaints with
respect to misappropriation of funds in capex projects, contracts issued for civil, mechanical &
instrumentation works. One of the employees at the project misappropriated cash by an act of
Phishing. The contracts were being allotted to the relatives of one of the senior officers in the
company. The complaints also included non-payment of salaries on a timely basis to the
contract workmen by the contractors.
There is no finance head to manage the Cyprus project. All finance related transactions are
also handled by the project manager.
Other issues faced by DPL
(1) The Company was also facing certain delays in receiving payments against the sales
made to its US customers. Four of the major customers constituting 20 % of USA sales,
have defaulted their payments to the company.
(2) In the background of multiple complaints, the Chief Financial Officer (CFO)
recommended slowing down the payment towards capex projects in Cyprus.
(3) As the Cyprus currency is highly fluctuating compared to US$, the CFO proposed to take
Credit default swaps to address the default risks faced by the Company, and sought
approval of the Board.
(4) In the recent Board meeting, Managing Director has updated the status of the above
challenges faced by the company covering USA FDA challenges, New API plant in
Cyprus, customer defaults, etc. and invited suggestions for solution.
(5) On the date of discussion of the default and intimation to the stock exchange there was a
sudden fall in the stock prices of the Company listed on the US & Indian stock
exchanges. Being a listed company, the Company is required to comply with the listing
agreement norms and include integrated reporting in its annual disclosures.

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PAPER – 6A: RISK MANAGEMENT 27

Multiple Choice Questions
Choose the most appropriate answer from the given options.
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(5.1) An event that has the probability of instantaneous or near instantaneous loss, and can be

c. o m
due to flash crashes, other market crisis, malicious activity by selected market

m risk
participants and other events is considered as:
s e
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a Liquidity risk
(A) Speculative
g la
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a (C) Technology risk
(D) Real time risk
(5.2) Which of the following risks is not a Political Risk?
(A) Exchange control risk
(B) Taxes & Regulatory Risk
(C) Human Development Index

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(D) Inefficient Legal System

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(5.3) In the case of export oriented units, uncertainty arising from global events is one of the

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reasons which start playing on the minds of shareholders. What is the most effective tool

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that assists to address this issue?
(A) Operational risk management
(B) Enterprise risk management a g
(C) Corporate governance module
(D) Country risk assessment
(5.4) Governance risks mean significant deficiencies that can impact the reputation, existence
and continuity of the organization. Such deficiencies would not occur because of:
(A) Inability of the Board to identify trivial risk facts that can impact business continuity.
(B) Inappropriate practices adopted by the Senior Management.
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(C) Failure of the Board to direct and control the organisation & evaluate whistle blower

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complaints.
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(D) Collusion of management to override significant internal control mechanism

l a financial losses.
a
ag (5.5) Phishing is ________
(A) A technique to create fraudulent transactions to benefit financially.
(B) A technique to encrypt the entire data on an individual or entity's computer system
to ruin the business.
(C) A fraud technique to get access to the victim's computer systems.

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28 FINAL EXAMINATION: MAY, 2023

(D) A financial transaction that an organization performs outside its network.
(2 x 5 = 10 Marks)
Descriptive Questions
(5.6) Describe under the Integrated Reporting what are the obligations of DPL with respect to
the Organisation's governance structure support its ability to create value in the short
medium and long term. (5 Marks)
(5.7) Discuss how the Credit Insurance and Credit Default Swaps (CDS) act as techniques to
mitigate default risks. Mention any five differences between the two. (5 Marks)
(5.8) DPL is considering to hedge its foreign exchange risk. For its imports made during the
period July-September 2022, it has to make a payment of US$ 60,000 on December 31,
2022. The present exchange rate is 1 US $ = ` 82. It can purchase forward 1 $ at ` 81.
The company will have to make an upfront premium @ 2% of the forward amount
purchased.
(a) In the following situations as on December 31, 2022, compute the exchange gain or
loss that DPL will make when the exchange rates are at:
(i) ` 85 per US $
(ii) ` 79 per US $
(iii) ` 82 per US $ (2 Marks)
(b) What is the difference between Forward Contracts and Futures Contract and which
is suitable for DPL to hedge its imports? (3 Marks)
Answer
Multiple Choice Questions
5.1 (D)
5.2 (C)
5.3 (B) or (D)
5.4 (A)
5.5 (C)
Descriptive Questions
5.6 The following are main obligations of DPL with respect to the organisation’s governance
structure support its ability to create value in the short, medium and long term. An
integrated report provides insight about how such matters as the following are linked to
its ability to create value:
• The organization’s leadership structure, including the skills and diversity (e.g., range
of backgrounds, gender, competence and experience) of those charged with
governance and whether regulatory requirements influence the design of the
governance structure.

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PAPER – 6A: RISK MANAGEMENT 29

• Specific processes used to make strategic decisions and to establish and monitor
the culture of the organization, including its attitude to risk and mechanisms for

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addressing integrity and ethical issues.

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•
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Particular actions those charged with governance have taken to influence and

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monitor the strategic direction of the organization and its approach to risk
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s eHow the organization’s culture, ethics and values are reflected in its use of and gla
management.

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•
on the capitals, including its relationships with key stakeholders.
Whether the organization is implementing governance practices that exceed legal
requirements.
• The responsibility those charged with governance take for promoting and enabling
innovation
• How remuneration and incentives are linked to value creation in the short, medium
and long term, including how they are linked to the organization’s use of and effects

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on the capitals.

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5.7 Credit Insurance is an insurance policy and a risk management product offered by private

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insurance companies and governmental export credit agencies to business entities

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wishing to protect their accounts receivable from loss due to credit risks such as

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protracted default, insolvency or bankruptcy.
A Credit Default Swap (CDS) is a financial swap agreement that the seller of the CDS will
compensate the buyer (usually the creditor of the reference loan) in the event of a loan
default (by the debtor) or other credit event. That is, the seller of the CDS insures the
buyer against some reference loan defaulting. The buyer of the CDS makes a series of
payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if
the loan defaults.
Differences between Credit Insurance and credit Default Swap

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1. The most important being that an insurance contract provides an indemnity against

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the losses actually suffered by the policy holder on an asset in which it holds an

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insurable interest. By contrast a CDS provides an equal payout to all holders,

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calculated using an agreed, market-wide method. The holder does not need to own

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the underlying security and does not even have to suffer a loss from the default

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event. The CDS can therefore be used to speculate on debt objects.

ag 2. The seller might in principle not be a regulated entity (though
banks).
3. The seller is not required to maintain reserves to cover the protection sold .
4. Insurance requires the buyer to disclose all known risks, while CDSs do not (the
CDS seller can in many cases still determine potential risk, as the debt instrumen t
being "insured" is a market commodity available for inspection, but in the case of

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30 FINAL EXAMINATION: MAY, 2023

certain instruments like CDOs made up of "slices" of debt packages, it can be
difficult to tell exactly what is being insured).
5. Insurers manage risk primarily by setting loss reserves based on the Law of large
numbers and actuarial analysis. Dealers in CDSs manage risk primarily by means of
hedging with other CDS deals and in the underlying bond markets.
6. CDS contracts are generally subject to mark-to-market accounting, introducing
income statement and balance sheet volatility while insurance contracts are not.
7. To cancel the insurance contract the buyer can typically stop paying premiums,
while for CDS the contract needs to be unwound.
5.8 (a)
(`)
Present Exchange Rate ` 81 = 1 US$
If company purchases US$ 60,000 forward premium is
60000 × 81 × 2% (Hedging Cost) 97,200
If exchange rate is ` 85
Then gain (` 85 – ` 81) for US$ 60,000 2,40,000
Less: Hedging cost 97,200
Net gain 1,42,800
If US$ = ` 79
Then loss (` 79 – ` 81) for US$ 60,000 1,20,000
Add: Hedging Cost 97,200
Total Loss 2,17,200
If US$ = ` 82
Then Gain (` 82 – ` 81) for US$ 60,000 60,000
Less: Hedging Cost 97,200
Total Loss 37,200
(b) Difference between forward and future contract is as follows:
Feature Forward Contract Futures Contract
Amount Flexible Standard amount
Maturity Any valid business date Standard date. Usually one
agreed to by the two delivery date such as the
parties second Tuesday of every
month
Furthest maturity Open 12 months forward
date

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Currencies traded All currencies Majors
Cross rates Available in one contract; Usually requires two

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Multiple contracts contracts

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avoided

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Market-place Global network Regular markets − futures
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market and exchanges

l a No daily limit in many Daily price limit set by
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currencies exchange
Risk Depends on counter Minimal due to margin
party requirements
Honouring of By taking and giving Mostly by a reverse
contract delivery transaction
Cash flow None until maturity date Initial margin plus ongoing
variation margin because of
market to market rate and

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final payment on maturity

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date

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Trading hours 24 hours a day 4 − 8 hours trading sessions
The company can choose eithersof
l a the two hedging techniques, depending upon the

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estimated changes in the currency rates.

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