A I t d ti AnIntroduction

ByRAJIVSRIVASTAVA
RISKDEFINED
Risk,intraditionalterms,isviewedasanegative.
Webstersdictionary forinstance definesriskas Webster sdictionary,forinstance,definesriskas
exposingtodangerorhazard.
TheChinesegiveamuchbetterdescriptionofrisk TheChinesegiveamuchbetterdescriptionofrisk
Thefirstisthesymbolfordanger,while
Th di h b lf i Thesecondisthesymbolforopportunity,
Makingriskamixofdangerandopportunity.
2
DerivativesandRiskManagement
RajivSrivastava
RISK Specificallydefined p y
Riskcanbedefinedasdeviationsoftheactualresults
fromexpected fromexpected.
Riskcanbeclassifiedtwoways 1)riskofsmall
losseswithfrequentoccurrencesand2)riskoflarge losseswithfrequentoccurrencesand2)riskoflarge
losseswithinfrequentoccurrences.
Theimpactormagnitudeofriskisnormally Theimpactormagnitudeofriskisnormally
estimatedfromfollowingtwofactors
1 Theprobabilityofanadverseeventhappening and 1. Theprobabilityofanadverseeventhappening,and
2. Incasetheeventoccursthemagnitudeofthelossit
cancause cancause.
3
DerivativesandRiskManagement
RajivSrivastava
CLASSIFICATIONOFRISK
PROJECTRISK FINANCIALRISK
O i l
PriceRisk
Operational
Regulatory
P liti l
PriceRisk
CurrencyRisk
QuantityRisk
Political
Liquidity
HumanResource
QuantityRisk
InterestRateRisk
Credit/DefaultRisk
HumanResource
Canonlybemanagedby
precautionsinappraisal
Credit/DefaultRisk
PortfolioRisk
Mostlymanagedbyfinancial p pp
Eventspecificriskare
managedbyinsurance.
y g y
toolssuchasdiversification
andthroughderivatives.
4
DerivativesandRiskManagement
RajivSrivastava
CLASSIFICATIONOFRISK
SYSTEMATIC/MARKETRISK UNSYSTEMATICRISK
Riskspecifictoagroupof
assets,ortheindustryorthe
k t h l
Riskspecifictoaparticular
asset.
marketasawhole.
Cannotbemanagedby
diversificationbutcanbe
Canbemanagedby
diversificationtoadesirable
extentbutcannotvanish diversificationbutcanbe
managedbyderivatives.
extentbutcannotvanish
altogether.
Someelementofriskremains
afterdiversification.
5
DerivativesandRiskManagement
RajivSrivastava
CLASSIFICATIONOFRISK
EVENTRISK BUSINESSRISK
Ri k f lll i hl
Riskoflargelosseswithsmall
probabilitysuchas
earthquake tsunami riots
Riskofsmalllosseswithlarge
probabilitysuchaspricerisk,
exchangeraterisk,interest
earthquake,tsunami,riots,
terrorismetc.
Mayaffectlargenumberof
exchangeraterisk,interest
raterisksspecifictoa
particularfirm.
y g
firms/individuals.
Canbemanagedbyinsurance
if h li i il bl
Mayaffectlargenumberof
firms/individuals.
Canbemanagedby
ifsuchpoliciesareavailable.
Canbemanagedby
derivatives.
6
DerivativesandRiskManagement
RajivSrivastava
MANAGINGRISK
Thewaystomanageriskincludeattempttocontrol
potentialdamage diffuse diversifyandtransferrisk potentialdamage,diffuse,diversifyandtransferrisk
tothosewillingtoacceptit.
Onecanmanagetheriskbytransferring itto Onecanmanagetheriskbytransferring itto
anotherpartywhoiswillingtoassumerisk.
Insurancecompanydoesnotdoanythingtocontain Insurancecompanydoesnotdoanythingtocontain
theriskpersebutassumesriskonyourbehalf.
M t f i kth hd i ti i Managementofriskthroughderivativesis
commonlyreferredashedgingwhichenables
offsettingofriskemanatingfromasituation offsettingofriskemanatingfromasituation.
7
DerivativesandRiskManagement
RajivSrivastava
STRATEGICANDTACTICALRISK
MANAGEMENT MANAGEMENT
Thebusinessrisksof
1. price,
2. exchangerate,and
3. interestrateasalsothecreditrisk
canbemanagedthroughderivatives.
Managementofriskthroughderivativesistacticalas
distinctfromstrategicmanagement.
Strategicmanagementiscostly,mostlyirreversible,time
consumingandrequiresseveralopinions.
8
DerivativesandRiskManagement
RajivSrivastava
DERIVATIVES
Derivativesareproductsthatderivetheirvaluefrom
someotherassetcalledunderlyingassetbutinother someotherassetcalledunderlyingassetbutinother
aspectstheymayremaindistinctlydifferentfromand
independentoftheunderlyingasset independentoftheunderlyingasset.
Managementofriskthroughderivativesincontrastto
strategicmanagementofriskis strategicmanagementofriskis
1. quick,
2 economical 2. economical,
3. reversible,and
4 mostlyprovidesprotectionintheshortterm 4. mostlyprovidesprotectionintheshortterm.
9
DerivativesandRiskManagement
RajivSrivastava
WHYMARKETFORDERIVATIVES
f h i fd i i li k d h h i l k Ifthepricesofderivativesarelinkedtothephysicalmarket
thenwhyhavederivativesasseparateinstrument?
S /Ph i lM k
Derivatives
Spot/PhysicalMarket
Derivatives
Market
PricefromSpotMarket
Enablestakeseparate,independentandopposite
positionsintwodifferentmarkets.
Ifpricesmoveintandemoppositepositionsintwomarkets
inmakeshedgingfeasible inmakeshedgingfeasible.
10
DerivativesandRiskManagement
RajivSrivastava
TYPESOFDERIVATIVES
Varietyofderivativesareavailablebothasstandard
productandtailormade,tosuitvariousapplications.
Fourbroadandbasictypesofinstrumentsare:
Forwards
Futures
Options,and p ,
Swaps,
Combinationsofderivativesarealsoavailablesuchas Combinationsofderivativesarealsoavailablesuchas
optionsonfutures,swaptionsetcformorecomplex
applications. pp
11
DerivativesandRiskManagement
RajivSrivastava
TYPESOFDERIVATIVES
Basedontheunderlyingasset Basedonhowtraded
h d l b b d d Theunderlyingassetcanbe
Commodities
Financial
Derivativescanbetraded
eitherontheexchangeorOTC
Overthecounter(OTC)
Financial
Currencies
Shares/Indices
( )
Forwards,
Options,
InterestRates
Credit
O h
Swaps
ExchangeTraded
Futures
Others
Weather
Energy
Futures,
Options
Energy
12
DerivativesandRiskManagement
RajivSrivastava
PARTICIPANTSINDERIVATIVE
MARKETS MARKETS
Hedgers:arethosewhousederivativesforhedgingi.e.
d li i t i k reduceoreliminaterisk.
Speculators:arethosetakepositionsinderivativesto
i b i i d i k Th increasereturnsbyassumingincreasedrisk.They
providemuchneededliquiditytomarkets.
A bi h h l i i i i i Arbitrageurs: arethosewhoexploitmispricingintwo
differentmarkets;Theyassumerisklessand
profitablepositionsunlikespeculators profitablepositionsunlikespeculators.
All3participantsareessentialforefficientfunctioning.
13
DerivativesandRiskManagement
RajivSrivastava
FUNCTIONSOFDERIVATIVES
3majorfunctionsofderivativesare:
Enablepricediscoverybecausetwoindependent Enablepricediscoverybecausetwoindependent
marketsareavailableforthesameasset.Itincreases
participationmakingmarketsdeep.Ifderivativesare p p g p
exchangetradedthentransparentpricesareavailable
worldwide.
Facilitatetransferofriskfromthosetryingtoavoid
tothosepreparedtoassumerisk. p p
Provideleveragetoattractspeculatorstoparticipate
andincreasemarketdepthenablingfairprice. p g p
14
DerivativesandRiskManagement
RajivSrivastava
CRITICISMOFDERIVATIVES
d l l h h d f ff Increasedvolatility:Thoughusedforefficientprice
discovery,derivativeswhenusedasaspeculativeproduct
canmakeincreasevolatilityinprices. canmakeincreasevolatilityinprices.
Increasedbankruptcies:Derivativesbeingleveraged
productshavecauseddisproportionatepositionsleading
toseveraldisastersandbankruptcies.
Increasedburdenofregulations:Mostderivativeshide
morethanwhattheyreveal liabilitiesbeingcontingentin morethanwhattheyreveal,liabilitiesbeingcontingentin
nature.Forfinancialdisciplineandbetterdisclosuresnew
ruleshavetobedevised.
Doubleedgedsword:Ifusedjudiciouslyitprovidesrisk
mitigationbutifusedinjudiciouslyitmagnifiesrisk.
15
DerivativesandRiskManagement
RajivSrivastava
RajivSrivastava
ji @h t il rajiv1234@hotmail.com
16
DerivativesandRiskManagement
RajivSrivastava