Risk & Risk Management:

Role of Financial
Derivatives

CLASS 1

Prof. Gagan Sharma

GROUND RULES FOR A MUTUALLY BENEFICIAL PARTNERSHIP

• Technical subject hence requires continuous efforts

• Simultaneous Reading is a must
• Practice Numerical Questions
• Class Participation is desirable
• No mobile phone usage in class
• No entry in class after 5 mins of start of the class
WHAT IS RISK ?

• As per business dictionary probability or threat of damage, injury,

liability, loss, or any other negative occurrence that is caused by
external or internal vulnerabilities, and that may be avoided through
pre-emptive action
• Risk Varies from industry to industry: Risk in Food Industry varies
from the Financial Industry
 WHAT IS RISK in FINANCE ?
• In finance, according to SEC, risk refers to the degree of uncertainty and/or potential
financial loss inherent in an investment decision. In general, as investment risks rise,
investors seek higher returns to compensate themselves for taking such risks.
• Its also seen as probability that an actual return on an investment will be lower than the
expected return. More is this probability, higher is the RISK.
• Some key types of Financial risk are:
– Country risk
– Default risk
– Underwriting risk
– Economic risk
– Exchange rate risk
– Interest rate risk
– Liquidity risk
– Political risk
– Sovereign risk
 TYPES OF RISK
• Business Risk
With a stock, you are purchasing a piece of ownership in a company. With a bond, you are
loaning money to a company. Returns from both of these investments require that that the
company stays in business. If a company goes bankrupt and its assets are liquidated, common
stockholders are the last in line to share in the proceeds. If there are assets, the company’s
bondholders will be paid first, then holders of preferred stock. If you are a common
stockholder, you get whatever is left, which may be nothing.
• Volatility Risk
Even when companies aren’t in danger of failing, their stock price may fluctuate up or
down. Large company stocks as a group, for example, have lost money on average about one
out of every three years. Market fluctuations can be unnerving to some investors. A stock’s
price can be affected by factors inside the company, such as a faulty product, or by events the
company has no control over, such as political or market events.
 TYPES OF RISK
• Inflation Risk
Inflation is a general upward movement of prices. Inflation reduces purchasing power, which
is a risk for investors receiving a fixed rate of interest. The principal concern for individuals
investing in cash equivalents is that inflation will erode returns

• Interest Rate Risk

Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will
receive the face value, plus interest. If sold before maturity, the bond may be worth more or less
than the face value. Rising interest rates will make newly issued bonds more appealing to
investors because the newer bonds will have a higher rate of interest than older ones. To sell an
older bond with a lower interest rate, you might have to sell it at a discount

• Liquidity Risk
This refers to the risk that investors won’t find a market for their securities, potentially preventing
them from buying or selling when they want. This can be the case with the more complicated
investment products. It may also be the case with products that charge a penalty for early
withdrawal or liquidation such as a certificate of deposit (CD).
 WHAT IS FINANCIAL RISK
MANAGEMENT ?
• It is the process of identifying, assessing and controlling threats to an
organization's capital and earnings. These threats, or risks, could stem from a
wide variety of sources, including financial uncertainty, legal liabilities,
strategic managements errors, accidents and natural disasters
• Stockbrokers use financial instruments like options and futures, and money
managers use strategies like portfolio and investment diversification to mitigate
or effectively manage risk
• In the financial world, risk management is the process of identification, analysis
and acceptance or mitigation of uncertainty in investment decisions.
• Essentially, risk management occurs when an investor or fund manager analyzes
and attempts to quantify the potential for losses in an investment and then takes
the appropriate action (or inaction) given his/her investment objectives and risk
tolerance
 NEED FOR RISK MANAGEMENT
• Financial risk management is about mitigating the risk of losing money. Companies
and people want to ensure they can survive, pay their debts, accumulate wealth and
have some money saved for the rainy days. This is where risk management comes in.

• It's about identifying, 3Ms, measuring, monitoring and mitigating risks to your
financial status, strategy and stability.
– Identifying - what events or factors can cause you to lose money?
– Measuring - how much money do you stand to lose if those events happen?
– Monitoring - are the events changing over time?
– Mitigating - what can you do now to avoid losing money in the case that those events occur?

• Whether you are a company or an individual, these questions are relevant. The
failure to do financial risk management means not thinking of your future and the
possibility of changing circumstances that could lead to poor outcomes.
• Inadequate risk management can result in severe consequences for companies,
individuals, and the economy. For example, the subprime mortgage meltdown in
2007 that helped trigger the Great Recession stemmed from poor risk-management
decisions
SOME MEASURES OF FINANCIAL RISK

Measure Meaning
Standard Deviation, (σ) Equity Portfolios
Duration/Modified Bond Portfolios
Duration/Macaulay’s Duration
Systematic Risk (β) Measure of Systematic risk (Market Risk)
Degree of Operating Leverage Sensitivity of operating income of a company in response to a change in
sales
Degree of Financial Leverage Sensitivity of shareholder’s return to Change in Debt
Delta Change in Price of option on change in price of underlying
Theta Change in Price of option over passage of time
Gamma Change in Price of option on change in Delta
Vega Change in Price of option on change in Volatility of price of underlying
Rho Change in Price of option on change in value of Risk free rate of return
Scenario/ Sensitivity Analysis Used id Corp Fin for estimating risk to projects
 RISK MANAGEMENT & DERIVATIVES?
Two types
of risk
The market “pays” you for bearing non-diversifiable
(systematic) risk only – not for bearing diversifiable risk.
In general the more non-diversifiable risk that you bear,
the greater the expected return to your investment. Systematic Unsystematic
Risk Risk

• Derivatives allow investors to better control the level of risk that

they bear.
• They can decrease or increase the level of systematic risk.

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 DERIVATIVE INSTRUMENTS

A derivative (or derivative security) is a financial

instrument whose value depends upon the value of
other, more basic, underlying variables.

Underlying Price Change Derivative Price Change

 WHAT IS A DERIVATIVE SECURITY?
• A Derivative Security is a security whose value depends on the values of other, more
basic underlying variables.
• Derivative security is a contract or agreement between 2 contract counterparties
• The counterparty who contracts to buy is said to have a long position while the
counterparty who contracts to sell is said to have short position
• In normal trading, an asset is acquired or sold. When we del with derivatives, asset
itself is not traded but the right to buy or sell the asset is traded

Example:
– An Indian exporter is likely to receive USD 1000 after one month goes to a bank and contracts to sell
the USD money for Rs.61 per USD.
– This contract is an example of derivative contract where the underlying is the foreign currency (USD)
WHAT IS A DERIVATIVE AS PER INDIAN LAW?
• In the Indian context the Securities Contracts (Regulation) Act, 1956
(SC(R)A) defines "derivative" to include —

– 1.2.1 A security derived from a debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for differences or any other form of
security

– 1.2.2 A contract which derives its value from the prices, or index of prices, of
underlying securities. Derivatives are securities under the SC(R)A and hence the
trading of derivatives is governed by the regulatory framework under the SC(R)A.
 NATURE OF THE INSTRUMENTS

 Underlying assets:
 Real asset – Physical assets such as wheat, oilseeds
 Financial asset – Interest rate, bond, stock, exchange rate,
credit characteristics
 Other assets – Weather, electricity, political events

 Unlike financial markets, derivative markets do not

create or destroy wealth – they merely provide a
means to transfer risk.
 WHY DO WE USE DERIVATIVES?

3 Purposes

Speculation Hedging

Arbitraging

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 WHY DERIVATIVES?
So why do we have derivatives and derivatives markets?

– Because they somehow allow investors to better control the level of

risk that they bear

– They can decrease or increase the level of systematic risk

– Limit ones losses under extreme uncertainties

 WHY DERIVATIVES ARE IMPORTANT ?
• Derivatives play a key role in transferring risks in the economy

• The underlying assets include stocks, currencies, interest rates,

commodities, debt instruments, electricity prices, insurance
payouts, the weather, etc.

• Many financial transactions have embedded derivatives

• The real options approach to assessing capital investment

decisions has become widely accepted
 TYPES OF DERIVATIVE MARKETS

• Exchange traded:
– Traditionally an open outcry system, but gradually switching to
electronic system
– No credit risk due to default because of standard contracts

• Over-the-counter (OTC):
– A network of dealers at financial institutions, corporations and
fund managers
– Contracts are non-standard and there is some credit risk involved
 PLAYERS IN DERIVATIVE MARKETS
• Hedgers:
Hedgers face risk associated with the price of an asset; they use these
instruments to reduce or eliminate that risk.
These are firms that face a business risk. They wish to get rid of this
uncertainty using a derivative. For example, an airline might use a derivatives
contract to hedge the risk that jet fuel prices might change.

• Speculators:
They bet on the future movement in the price of an asset.
These instruments give them large leverage – by putting small amount of
money, they can take large positions – large potential gains / losses.

• Arbitrageurs:
They trade ( taking offsetting positions in 2 or more instruments) to profit from
the disequilibrium or imperfections in prices in different markets – cash and
derivative.

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 HEDGERS
• Hedgers are essentially spot market players.

• Hedgers are interested in reducing price risk (that they already

face in the spot market) with derivative contracts and options.

• Forward contracts are designed to neutralize risk by fixing the

price that hedger will pay or receive for the underlying asset.

• Future contracts can be used to undertake minimum variation

hedging.

• Option strategy enables the hedger to insure itself against

adverse exchange rate movements while still benefiting from
favorable movements.

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 SPECULATORS

• Speculators wish to take a position in the market

either by betting that the price will go up or down.

• Futures and options can be used for speculation

• When a speculator uses futures then the potential

gain or loss is high.

• When a speculator uses options, speculator’s loss is

limited to the amount paid for the option.

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 ARBITRAGEURS
• Arbitrage involves locking in a riskless profit by simultaneously entering into
transactions in two markets.

Example:
– Consider a stock that is traded in both New York and London. Suppose
that the stock price is $172 in New York and £100 in London at a time
when the exchange rate is $1.7500 per pound

– An arbitrageur could simultaneously buy 100 shares of the stock in New

York and sell them in London

– He will obtain a risk-free profit of:

100*($1.75*100 – $172) or $300 in the absence of transactions costs.
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 CONCEPT OF ARBITRAGE
• Arbitrage means that it is possible to trade to generate riskless profit
without investment

• An arbitrageur is a person who engages in arbitrage

Eg: Buy one share of IBM on Boston exchange for 105$
Sell one share of IBM on New York exchange for 110$

These 2 transactions generate riskless profit of 5$ (both trade assumed to

occur simultaneously hence no investment). Other assumptions- no
transaction costs, no taxes, no market imperfections etc

• Derivative Pricing assumes no arbitrage opportunities

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ROLE OF FINANCIAL DERIVATIVES

• Market Completeness
• Speculation
• Risk Management
• Trading Efficiency
• Price Discovery