1. THEME
Risk Engineering
Chart - 1
R
isk Engineering re-
fers to unanticipated
changes attributed to
company’s assets, liabilities
and operating income. Any
business decision has got two
fundamental parameters –
‘Risk’ and Return. Risk Engi-
neering deals with establishing now no longer be merely a The SOX goes much deeper
a trade off between these two management concept, which than just the accuracy of finan-
parameters so as to maximise the management applies inter cial projections; it touches on
shareholders’ wealth.
many areas that affect project
management. It is not too late
Sapan Anil The only thing certain in these changing times is ‘un- to have the waves of Sarbanes-
Sanghani certainty’ and a ‘Risk’ is basically linked to such uncertain- Oxley Act being multiplied in
The author is a member ties. Although the future and risk cannot be predicted 100 Indian Business World.
of the Institute and
working as Officer -- F &
per cent, still ‘precaution is always better than cure’. And the “Risk Engineering is like
A, Niko Resources Ltd. way we manage and mitigate such risks is broadly called ‘Risk
She can be reached at ‘Going Back To The Future’.
Engineering’. Risk Engineering is an ‘Art’ and not ‘Science’.
sapan@nikoindia.com
It’s not about conquering the
There is no specific, defined, well-delineated or scientific way
by which risk can be engineered. It can be said that Risk En- future but managing the fu-
gineering is ‘Scientific Art’ or ‘Artistic Science’. Read on to ture by taking suitable actions
take a peek into the depths of the concept. in present.
Change is something,
which is permanent; in this
Today, every business is nally for purpose of mitigating change uncertainty is some-
exposed to some or the other its exposure to Risk. For In- thing, which is certain; in this
risk, which affects its profit- stance Clause 49 of the Listing uncertainty Risk Engineer-
ability and cash-flows. Any Agreement has been amended ing is a measure for survival,
business cannot be fully safe- wherein the corporates are prevention, growth, expansion
guarded against the uncertain- now required to provide in the and value addition”.
ties of future, but it can cer- report on Corporate Gover- The rationale is – Survival
tainly take steps to reasonably nance, the Risk Management of the Fittest.
hedge itself from future risks. and Risk Mitigation Policies
Risk refers to degree of adopted by the management.
variability of actual returns from Business Risk
The new buzz in US econ- There are many and di-
expected returns associated omy is that – Is Poor Project
with given assets/investments. versified operational risks in-
Management a Crime? The
The future is uncertain but still herent in every business. Few
answer could be ‘yes’ since now
scientific projections are made the Sarbanes-Oxley Act makes Risk Hedging Tools available
to prepare for the same. One senior executives criminally li- have been discerned as under.
thing that is sure is that risk can able for not making reason- Standard Deviation (d) and
seldom be eliminated. With lu- able and sufficient endeavours Coefficient of Variation:
crative measures being taken it to identify risks their business These are statistical mea-
can only be managed and engi- is exposed and taking mea- sures used to quantify risk. It
neered so as to mitigate its ef- sures to mitigate such risks. In measures the variance from
fects on the business. the wake of several account- estimations and budgets in re-
Risk can broadly be cat- ing scandals the US Congress spect of production, cost and
egorised in as Chart - 1. passed a law, referred to as the expenses. Standard Deviation
Sarbanes-Oxley Act of 2002 is an absolute measure while
Giving Statutory Colours to (SOX), which holds CEOs Coefficient of Variation is a
Risk Engineering and CFOs criminally liable for relative model. It is expressed
Risk Engineering will relating fraud to shareholders. in the same units as the range
October 2005 The Chartered Accountant 559

2. RISK ENGINEERING WEB
560 The Chartered Accountant October 2005

3. RISK PROFILE Substituting the above
values in following equations.
Y = mx +c.
∑y = m.∑x + n.c
∑xy = n.∑x^2 + c. ∑x, we
get
y = 1.243x + 0.666.
Thus, profit for year 2005-
06 with weight (x) of 7 should
be 9.37 crore and profit for
year 2006-07 with weight (x)
of 9 should be 11.85.
This tool can be extremely
useful in projections of future
parameters and then compar-
ing the actual results with the
projections. However, the ba-
sic requirement for this tool is
that the variable (profit in this
case) should follow an increas-
ing or decreasing trend.
Earned Value Management &
Cost Performance Index: This
is statistical technique used
mainly to gauge performance
of the company on the basis
of budgeted performance. The
significance of this technique
in project management and
risk hedging is exemplified
using following example.
For Instance – The bud-
of probable outcomes is ex- wherein just by feeding few geted & actual data are as
pressed i.e. if you are apply- figures a rough estimate can under: -
ing the to evaluate per cent be made of net profit for any Prima Facie the above cata-
returns in a project, is ex- future period(s). logued figures manifests that
pressed in per centage terms. The use of Regression the expenditure is within
It doesn’t directly hedge busi- Analysis is exemplified as the limits and the company
ness risks but provides value under: - has performed according to
added information to the de- ∑x=0, ∑xy=87, ∑x^2=70, planned estimates. But the
cision makers enabling them ∑y=9, n=6.
to make sound decisions and
thereby preclude the adversity Rs. In Crores.
of any risks. Year Profit Weights
Regression Analysis: This is y x xy x^2
also a statistical tool, which
provides a Decision Making
Model thereby enabling the 1999-00 (5) (5) 25 25
decision maker to take sound
decisions. It is based on analy- 2000-01 (3) (3) 9 9
sis of past trend and data. This 2001-02 1 (1) (1) 1
decision-making model assists 2002-03 4 1 4 1
in making accurate future pro-
jections and predictions. 2003-04 5 3 15 9
For Instance - Based on 2004-05 7 5 35 25
past trend in the net profit
of the company, a statisti-
cal model can be developed ∑ 9 - 87 70
October 2005 The Chartered Accountant 561

4. Particulars Budgeted Actual (55/0.75). within (i) specific time frame
Amount Amount Schedule Per- (ii) at specified cost and (iii)
formance Index is meeting the performance
Exploration 100 crore 85 crore akin to CPI except standards. Critical Path
Development 120 crore 95 crore that in SPI the Analysis is one of the most
formula is Earned lucrative tool for successful
Total 220 crore 180 crore
Value for a Schedule project execution. Its major
budgeted amount is for the Pe r iod/Budgeted advantages interalia includes
entire project i.e. 100 per cent amount for a Schedule Period. –
completion whereas the actual It measures performance of - Comprehensive
completion is say, only 75 per project for particular period view of entire proj-
cent. Hence, the actual com- rather than on cumulative ect.
parison should be as under. basis. - Effective time
Cost of Per- scheduling.
Particulars Budgeted Actual formance Index - Identification of
Amount (75 Amount and Schedule critical activities
per cent) Performance In- of any project and
Exploration 75 crore 85 crore dex are based on continuous focus on
the concept of it.
Development 90 crore 95 crore ‘Management - Breaking down of
Total 165 crore 180 crore By Exception’. project into differ-
Management ent components for
The realistic figures as has to focus on better control and
juxtaposed above show that only those areas, which do vigilance.
the expenditure has in fact not perform according to - Control based on
exceeded the budgeted fig- planned estimates. For this Principle of Elimi-
ures and the company has purpose, CPI & SPI needs nation.
not performed as per planned to be calculated for each line - Optimum Resource
estimates. Thus, the calcula- of cost and also on overall Allocation.
tions of the management can basis.
go wrong if the decisions Simulation Technique: Simu-
are taken based on the first lation is a quantitative tech-
table. nique wherein organised
In the above table, Rs. series of trial and error ex-
165 crore is called Earned periments are conducted to
Value out of Rs. 220 crore of predict the future behaviour.
the budgeted figures. For Instance if probabi-
Cumulative Earned Value/ listic estimates of Turnover,
Cumulative Budgeted Amount Net Profit or any other fi-
i.e. 165/220 = 0.75 is called nancial parameter are made
Cost Performance Index. available, a series of trial and
CPI below one is an indicator error experiments can be
of unfavourable performance. conducted on these estimates
It means that for every ru- and reasonable accuracy can
pee spent by the company be achieved in making pre-
the company achieves value diction about turnover or
worth Rs. 0.75. CPI above net profit or any other finan-
one is desirable. cial parameter for the future
Balance budgeted amount period(s).
i.e. Rs. 55 (220-165) divided Critical Path Analysis: It is a
by CPI i.e. 0.75 gives the quantitative technique that
balance expenditure which allows a comprehensive view
should be incurred if the of the project. A project usu-
current performance is as- ally involves a set of activities
sumed to continue in future or jobs that are performed in
as well. Thus, the further ex- certain sequence determined
penditure should be within logically or technologically
overall limits of Rs. 73.333 and it has to be completed
562 The Chartered Accountant October 2005

5. Project Evaluation & Review volatile foreign exchange vantage of forces of demand
Technique [PERT] markets. and supply in currency mar-
Critical Path Analysis is The measures available ket. Currency rates between
incapable of handling un- to hedge against these risks two countries, which are not
certainty in timing, which are common. theoretically determined but
is an impediment in turnkey Forward Contracts: For- are based on the forces of de-
projects such as oil explora- ward contracts are contracts
tion. PERT takes care of this mand and supply in the in-
to buy or sell foreign cur-
uncertainty involved in any rency or crude oil at a speci- ternational market.
project. However, for this, fied rate on a specified date. This technique can be
management needs to pro- It involves cost in the form more useful in case where a
vide three kinds of proba- of forward premium. This is company has its holding or
bilistic estimates namely the most common technique subsidiary in another coun-
– Optimistic, Pessimistic and used today across various in- try with different reporting
Most Likely. In short, PERT dustries to hedge against fi- currency. In that case, both
is a combination of Probabil- nancial risks. the company can work out
ity Distribution and Critical This has been exempli- on suitable policy w.r.t cur-
Path Analysis. fied using the following in- rency swaps whereby both
Net Present Value & Profit- stance.
ability Index: These are Fi- the companies are benefited
Say, Company A is to
nancial Tools usually used for make payment of USD 1 and their respective risks are
making appraisal of Capital million on 31.03.05. On hedged.
Budgeting proposals. They 01.01.05 it enters into for- The benefit of this engi-
help in justifying financial ward contract when the spot neering tool is exemplified as
viability of any capital in- rate is 1 USD = Rs. 44.34. under: -
vestment based on the cash The forward rate is 44.50. Suppose Company A
flows provided over the life Thus the contract is at for- (subsidiary or affiliate) incor-
of that investment. ward premium of 1.44 per porated in India has availed
Estimation of Future cent [(44.50-44.34)/44.50 x loan of Rs. 44,00,00,000
Cash Flows would also aid in 12/3 x 100]. from State Bank of India and
compliance with AS-28 ‘Im- Company A will have to Company B incorporated in
pairment of Assets’ issued by pay the premium amount of
ICAI. Britain (parent) has availed
Rs. 14,400 on 01.01.05.
Internal Rate of Return: On 31.03.05 A would a loan of USD 1,00,00,000
Internal Rate of Return is have to make payment @ 1 from Bank of America. Both
again a financial tool used USD = Rs. 44.50. Say the the companies decide to en-
to measure the financial vi- spot rate on that date was 1 ter in Currency swaps with
ability of any investment USD = Rs. 44.55. Thus the each other whereby they
based on the return likely to net savings of the company decide to exchange their re-
be generated by it. It is the would be as under. spective debts.
rate at which present value of Let’s see how
future cash outflows is equal Savings [Rs. 44.55 – Rs. Rs. 50,000. currency swap can
to present value of cash out- 44.50] x 1 million. benefit both of
flows. In a way, it is bottom-
line rate of return, which ev- Less: forward premium Rs. 14,400. them.
ery investment should yield Consider the
Net Savings Rs. 35,600.
in order to be in better off following rates –
situation. 1. 1 USD = Rs. 43.91.
Currency Swaps: This in- 2. 1 GBP = Rs. 82.88.
Financial Risks volves exchange of company’s 3. 1 GBP = USD 1.88.
This can be again classi- receivables or payables de- - If A had not entered
fied into two groups – nominated in foreign curren- in currency swap, it would
- Risk associated cy with any other company’s have to pay Rs. 44,00,00,000
with sporadic in- assets or liabilities denomi- to SBI.
ternational product nated in a different foreign - If B had not entered
prices. currency. It basically involves in currency swap, it
- Risk associated with arbitrating and taking the ad- would have to pay GBP
October 2005 The Chartered Accountant 563

6. 53,19,149 [1,00,00,000 A fixed interest payment compared to ABC Ltd.
USD / 1.88]. may be swapped (convert- - Both the companies have
- After entering into cur- ed) into a floating interest outstanding loan of Rs.
rency swap agreement, A rate payment and vice versa. 50 Crore.
would have to pay loan of Thus, floating rate borrowers - XYZ has gone for fixed
B of USD 1,00,00,000. can swap their commitments interest rate while ABC
As a result, cash outflow for fixed rate and vice versa. has gone for floating in-
for A would amount A floating to fixed swap terest rate.
to Rs. 43,91,00,000. will be taken if the rates are - XYZ expects the interest
[1,00,00,000 USD x Rs. expected to increase and rate to fall and is there-
43.91] fixed to floating rate swap fore willing to shift to
- Similarly, after entering will be taken if the rate are Floating Interest Rate.
into currency swap agree- perceived to fall. - ABC expects the inter-
ment, B would have to Let’s understand with est rate to rise and is
pay GBP 53,08,880 [Rs. the help of suitable example. therefore willing to shift
44,00,00,000/82.88]. to Fixed Interest Rate.
- Thus, the desired inter-
XYZ LTD ABC LTD (Ci- est rate for XYZ is MI-
(ICICI) tibank) BOR + 0.40 per cent
and desired interest rate
Fixed Interest Rate 10 per cent 11 per cent
for ABC is 11 per cent.
Floating Interest Rate MIBOR + 0.40 MIBOR + 0.80 How the Gain is Com-
per cent per cent puted?
Thus the net gain due to Desired Interest Rates MIBOR + 0.40 per
Background if they had not entered cent + 11 per cent
Currency Swap Agreement to - XYZ Ltd enjoys high- in IRS Agreement.
both the companies would be er creditworthiness as
Interest Rates if they 10 per cent + MI-
enter into IRS Agree- BOR + 0.80 per
ment. cent
Gain if they enter into 0.60 per cent
IRS Agreement.
Both the companies may
mutually agree that the gain
of 0.60 per cent shall be di-
NET BENEFIT = GBP10269 NET BENEFIT = Rs. 900,000
vided between XYZ and
Interest Rate Swap
Agreements:
Interest Rate Swap (IRS)
is an agreement between two
parties who exchange inter-
est payments based on a no-
tional principal amount over
an agreed period of time. The
following can be the objec-
tives of interest rate swaps.
- To protect or alter the in-
terest rate on borrowings.
- To alter the frequency
and size of the cash flow
profile.
564 The Chartered Accountant October 2005

7. ABC say, in the ratio of 2:1, risk where the underlying asset risk is limited to the amount of
taking into consideration the can either be foreign currency premium to be paid at the time
creditworthiness enjoyed by or international product prices, of buying an option.
them. Accordingly, XYZ will both of which are subject to On the other hand, for
be benefited by 0.40 per cent volatile movements. the option writer (Seller), the
and ABC will be benefited benefits are limited to option
by 0.20 per cent. Options: premium received while cost
Options are agreements or risk is unlimited.
Mechanism wherein the option holder Actual delivery of the un-
MIBOR + 0.40 per cent (Buyer) has a right to buy or derlying assets does not take
place and the transaction is
settled by making payment
of the differential amount.
In case of options the un-
derlying asset can be currency,
product prices, interest rates or
share prices. The options de-
rive their value from the value
of their under-
Swap Pay-off Table lying assets.
Pay to bank Pay to other Receipt Net pay Desired rate Benefit Futures:
party from other out cost Futures are
party akin to options
XYZ 10 per cent MIBOR+0.4 10.40 per MIBOR MIBOR+0.4 0.4 per but unlike op-
per cent cent per cent cent tions, the buyer
ABC MIBOR+0.8 10.40 per cent MIBOR+0.4 10.80 11 per cent 0.2 per in futures does
per cent per cent per cent cent have an obliga-
tion to buy or
Futures & Options: sell specific quantity of an un- sell specified quantity of un-
With avalanche of trading derlying asset at a specified derlying asset at a specified
in derivatives market, these price on or before a specified date on or before a specified
tools have become favorites date. It is to be noted that the date. The buyer cannot elude
of many companies for Risk buyer has a right but does not himself from his obligations
Engineering. have an obligation to do so. In in case of futures. In a way,
The company can enter a way, the benefits for the buyer the risk in case of futures is
into agreement for hedging are unlimited while the cost or equal both for the buyer and
the seller.
These derivatives can
prove to be one of the most
lucrative tools for hedging
company’s financial risk, as
far as product prices in the
international market and
foreign currency rates are
concerned.
Many companies have
reported huge profits in the
Lamiya Lokhandwala
form of paper gains through
efficient Treasury Operations
& Risk Management and at
the same time hedging its fi-
nancial risks. Ë
October 2005 The Chartered Accountant 565