It gives a brief in sites about exchange rate and credit rate risks..

1. MANAGEMENT OF CREDIT RISK
AND EXCHANGE RATE RISK WITH
EXAMPLES

2. CREDIT RISK MANAGEMENT
“Probability of loss from a credit transaction” is the
general definition of credit risk. “Credit Risk is most
simply defined as the potential that a borrower or
counter-party will fail to meet its obligations in
accordance with agreed terms”.
Risk where borrower cannot pay interest rat nor
principle according to contracts.

3. • It involves identifying and analyzing risk in a credit
transaction
• It revolves around measuring, managing and controlling
credit risk in the context of an organization’s credit
philosophy and credit appetite.
• It is predominantly concerned with probability of default.
• Depending on the risk manifestations of an exposure, an
exist route remains a usual option through the sale of
assets/securitization
• Statistical tools like VaR (Value at Risk), CVaR (Credit
Value at Risk), duration and simulation techniques, etc.
form the core of credit risk management
• It is forward looking in its assessment, looking, for
instance, at a likely scenario of an adverse outcome in the
business

4. For Example
 A consumer may fail to may a payment due on a
mortgage loan, credit card, or any other loan.
An insolvent insurance company does not pay a policy
obligation
An insolvent bank won’t return funds to a depositor
A government grants bankruptcy protection to an
insolvent consumer or business

5. Framework of Credit risk management
Control of individual loans
Risk management of the loan portfolio

6. Control of individual loans
Credit worthiness of customers
1) ability to pay
2) willingness to pay
 Amount of credit granted
1) When creditworthiness is good, amount of credit can
be increased.

7. How to measure creditworthiness
Probability of default (PD)
• Probability in which customers will default in certain time
horizon.
• PD can be calculated by using data of customers
• PD is assigned to each customer
How to calculate:
 Logistic regression model is usually used to calculate
probability of default.
 Data should have the results where customers are default or
not default
Logistic regression model produces outputs between 0 and 1
from data.
These outputs are considered as probability.

8. Logistic regression model
• PD= exp(βX)/(1+exp(βX))
• X : risk factors such as Income, occupation, age, sex,
credit history etc.
and Revenue profits, stock price, capital ratio, etc.
β: Coefficients to risk factors.

9. Credit Rating:
 Rating is assigned to each customer according to
probability of default and other information of customers
AAA is usually the highest rating
C- is usually the lowest rating

10. Risk management of the loan portfolio
Basic concept:
• Avoid the concentration in the portfolio.
• Correlation over expected defaults among customers
should be controlled
• Do not put all eggs in the same basket

11. In assessing credit risk from a single
counter party, an institution must consider
three issues.
• Default probability: What is the likelihood that the
counterparty will default on its obligation either over the
life of the obligation or over some specified horizon, such
as a year?
• Credit exposure: In the event of a default, how large will
the outstanding obligation be when the default occurs?
• Recovery Rate: In the event of a default, what fraction of
the exposure may be recovered through bankruptcy
proceeding or some other form of settlement?

12. Types of Credit Risk Management:
• Credit Default Risk: The risk of loss arising from a debtor
being unlikely to pay its loan obligations in full or the debtor is
more than 90 days past due on any material credit obligation. It
including loans, securities and derivatives.
• Concentration Risk: The risk associated with any single
exposure or group of exposures with the potential to produce
large enough losses to threaten a bank’s core operations. It
may arise in the form of single name concentration or industry
concentration.
• Country Risk: The risk of loss arising form a sovereign state
freezing foreign currency payments r when it defaults on its
obligations. This type of risk prominently associated with the
country’s macroeconomic performance and its political stability.

13. Mostly all banks today practice credit risk management.
They understand the importance of credit risk management
and think of it as a ladder to growth by reducing their
NPA’s. Moreover they are now using it as a tool to succeed
over their competition because credit risk management
practices reduce risk and improve return capital.
Credit Risk Management philosophy

14. Goals of Credit Risk Management
 Maintaining risk-return discipline by keeping risk exposure within
acceptable parameters.
 Fixing proper exposure limits, keeping in view the risk philosophy and
risk appetite of the organization.
 Handling credit risk both on an “entire portfolio” basis and on an
“individual credit or transaction” basis.
 Maintaining an appropriate balance between credit risk and other risks
 Creating and maintaining a respectable and credit risk management
culture to ensure quality credit portfolio.
 Keeping “consistency and transparency “as the watchwords in credit risk
management

15. The Credit Risk Management Process
The risk management process has four
components:
 Risk Identification.
 Risk Measurement.
 Risk Monitoring.
 Risk Control.

16. Meaning of Exchange Rate Risk
• Risk of fluctuating value of a currency over time
• If the time and size of cash inflows in one currency does
not match the time and size of cash outflows in the same
currency, we face exchange rate risk
• Impacts dollar value of foreign currency cash inflows and
foreign currency cash outflows
• If we have foreign currency cash inflows, we face risk of
foreign currency depreciating against domestic currency
• If we have foreign currency cash outflows, we face risk of
foreign currency appreciating against domestic currency

17. Types of Exchange Rate Exposures
Transaction Exposure
 Translation Exposure
 Economic Exposure

18. Transaction Exposure
• Only companies engaged in global business
and doing transactions in foreign currency face
this risk
• Arises due foreign currency transactions of a
firm
• Arises from the possibility of incurring future
exchange gains/losses on transactions already
entered into and denominated in a foreign
currency.

19. Measuring Transaction Exposure
• Determine the projected net amount of inflows or outflows
in each foreign currency
• Determine the overall risk of exposure to these currencies
• To determine the amount of transaction exposure, keep in
mind the following:
• The net exposure of all subsidiaries combined
• Range of possible exchange rates
• Range of cash inflows and outflows
• Standard Deviation of currencies
• Correlations among currencies

20. Translation Exposure
• The exposure of the MNC’s consolidated financial
statements to exchange rate fluctuations
• If the assets/liabilities are translated at something other
than the historical exchange rates, the Balance Sheet will
be affected by fluctuations in currency values over time

21. Economic Exposure
• The extent to which the economic value of a company can decline
because of exchange rate changes
• Decline can be due to a decline in the level of expected cash flows or
an increase in the riskiness of these cash flows
• Overall effect of exchange rate changes in competitive relationships
between alternative foreign locations
• Extent of exposure depends on
• structure of markets for a firm’s product
• Price elasticity of demand for the product
• Availability of close substitutes for the product
• Even pure domestic firms may face economic exposure

22. Management of Transaction Exposure
• Foreign currency cash outflows
• Risk: Foreign currency may become more
expensive/appreciate against domestic currency
• Strategy: Buy foreign currency futures, forwards, or call
options
• Foreign currency cash inflows
• Risk: Foreign currency may become more
cheap/depreciate against domestic currency
• Strategy: Sell foreign currency futures, forwards, or buy
put options

23. Management of Economic Exposure
• Marketing Initiatives
• Market Selection
• Pricing Strategy
• Product Strategy
• Promotion Strategy
• Production Initiatives
• Product sourcing and input mix
• Plant location
• Raise Productivity
• Financial Initiatives

24. Marketing Initiatives
• Shall we pull out of a market that has been rendered
unprofitable due to competition or shall we differentiate
the product and concentrate on specific customers only?
• Shall we emphasize market share or profit margin in
response to weak domestic currency?
• Shall we add/drop a product to our product line in
response to exchange rate changes?
• Where to advertise?

25. Production Initiatives
• Outsource your inputs/raw materials/components in
response to strong domestic currency
• Change input mix to reduce cost in response to strong
domestic currency
• Shift production to weak currency area in response to
strong domestic currency
• Raise productivity by cutting costs—produce the same
number of units at a lower cost or produce more units at
the same cost

26. Financial Initiatives
• Equate the sensitivity of costs and revenues to exchange
rate changes