National Institute of Business Management

Chennai - 020
EMBA/ MBA

Elective: FINANCIAL RISK MANAGEMENT (Part -1)

Attend any 4 questions. Each question carries 25 marks

(Each answer should be of minimum 2 pages / of 300 words)

1.

What are the sources of Risk. Explain.

Answer:Business Risk(more particularly for Banks or financial instituions :In every business there is a chance of loss, because future is uncertain. So business
risks means the occurrence of those events which become the cause of loss in the
business. A businessman earns the profit at the risk of loss. So risk is an essential
element in business. While in business decision making means the evaluation of
risks and profits involved in business activities.
There are large number of uncertain events in business like fall in demand, strike of
workers, theft, break down of machinery etc.
KINDS or TYPES OF BUSINESS RISK :The risk may be classified in to various types. Following are the important kinds of
risks :
1.
2.
3.
4.
5.

By
By
By
By
By

Organization.
Occurrence Events.
Nature.
Controllable.
Protection.

1. CLASSIFICATION OF ORGANIZATION :In this regard there are two types of risks :

A. Internal Risks :This risks of losses due to internal affairs of the business organization are called
internal risks. These can be normally controlled by management.
B. External Risks :There are large number of external factors like fall in demand due to war or the
change in fashion are called the external factors which become the cause of loss. So
such type of risks of losses are called external risks. Normally these are beyond the
control of an organization.
2. CLASSIFICATION BY OCCURRENCE EVENT :It has two kinds :
A. Property Risks :If due to any event property of the firm destroys it will be called property risks. For
example if building of the firm destroys due to fire, it will be called property risk.
B. Liability Risks :Some time a firm held responsible for losses by any other firm or a person. Such
type of losses risks are known liability risks. For example there is a firm which is
providing food to the people now if one person eats the food and dies. Now a firm
will be held responsible for such loss.
3. CLASSIFICATION BY NATURE :It can be classified in two types :
A. Speculative Risks :In this risk the chance of profit and loss both are involved. Each firm starts the
business to earn a profit. It is the basic objective of each firm but due to some
uncertain events and firm suffers loss. For example a firm produces a new product,
now there is a chance that it may capture the market and earn a profit. On other
aside if it fails to create the demand then it suffers a loss.
B. Pure Risks :In such types of risks there is no chance of profit and possibility of losses are pure.
For example in case of destruction of ship there is a pure risk.
4. CLASSIFICATION OF CONTROL LIABILITY :It has following two kinds :

A. Controllable risks :If management of business can control the risks by making the favorable decision
these are called controllable risks. For example there a loss due to the
regular breakdown of electricity, this can be controlled by the management by using
the generators of electricity.
B. Uncontrollable Risks :Some risks are beyond the control of management. For example war spreads in the
world and a firm suffer a loss due to fall in the exports. Such type of loss is called
uncontrollable.
5. CLASSIFICATION BY PROTECTION OF RISKS :In this case there are two types of risks :
A. Insurable Risks :If the risks can be controlled by purchasing the insurance policy it is called insurable
risks. Such type of loss is covered by the insurance company. In such cases loss is
shifted from insured to the insurance company. The losses which may occur due to
the fire, accident or theft are included in the insurable risks. In case of insurable
risks following conditions must be fulfilled.
1.
2.
3.
4.
5.
6.
7.

The losses must be calculate able.

The loss must not be caused internationally.
The cost of insuring must be feasible.
There should be an insurable interest for the insured.
To get insurance there should be large number of similar cases.
Loss probability must be predictable.
Expected over loss should be spread over the total number of insured.

B. Non Insurable Risks :If we cannot purchase the insurance policy against any risk, it is called non
insurable risks. For example if the price of cotton falls in the market due to any
reason, and a businessman suffers a loss, such type of loss is not insurable.
PROTECTION METHODS OF RISKS :There is two types of protection methods of risks :
A. By Insurance Policy.
B. Non Insurable Methods.
A. By Insurance Policy :Management purchases the insurance policy to protect the business from losses
caused due to risks. A firm or a person when pays a premium to the insurance

company, risk of loss transfers to insurance company. In case of insurable risks, this
method can be used.
B. Non Insurable Methods :When the risks are non insurable and these can not be protected by the insurance
the other techniques can be used to protect these risks. These are following :
1. Precautionary Measures :In some cases it is not possible to avoid the risk the precautionary measures can be
adopted to reduce the risk. For example in case of production proper planning
should be made and market should be also tested. How the product will compete
the market price , quality and quantity? Necessary measures must be taken to start
the business.
2. Contingency Fund :To cover the unexpected losses companies set a side an amount from the current
revenue to establish this fund compensates the loss from this fund. So by using this
fund a firm saves itself from any financial loss.
3. To Avoid the Risks :Management can adopt the technique to minimize the chance of occurring any
particular event which may cause the loss. All the risks can not be avoided but
these can be minimized. So such policies are adopted which reduce the loss. For
example there is a greater risk to send the product by air then by train. So the risk
can be reduced by sending the product by train. Similarly when you introduce new
product, there is a greater risk, so you may refuses to avoid the risk.

Types of Financial Risks:

Financial risk is one of the high-priority risk types for every business. Financial risk is
caused due to market movements and market movements can include host of
factors. Based on this, financial risk can be classified into various types such as
Market Risk, Credit Risk, Liquidity Risk, Operational Risk and Legal Risk.

Market Risk:
This type of risk arises due to movement in prices of financial instrument. Market

risk can be classified as Directional Risk and Non - Directional Risk .

Directional risk is caused due to movement in stock price, interest rates and more.
Non- Directional risk on the other hand can be volatility risks.

Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their

counter parties.Credit risk can be classified into Sovereign Risk and Settlement

Risk . Sovereign risk usually arises due to difficult foreign exchange policies.
Settlement risk on the other hand arises when one party makes the payment while
the other party fails to fulfill the obligations.

Liquidity Risk:
This type of risk arises out of inability to execute transactions. Liquidity risk can
be classified into Asset Liquidity Risk and Funding Liquidity Risk .

Asset Liquidity risk arises either due to insufficient buyers or insufficient sellers
against sell orders and buy orders respectively.
Operational Risk:

This type of risk arises out of operational failures such as mismanagement or

technical failures. Operational risk can be classified into Fraud Risk and Model

Risk . Fraud risk arises due to lack of controls and Model risk arises due to
incorrect model application.
Legal Risk:

This type of financial risk arises out of legal constraints such as lawsuits.
Whenever a company needs to face financial loses out of legal proceedings, it is
legal risk.

2. Explain Risk Management Approaches.

Financial Risk Management:
In a financial services context, risk is defined as "the lack of predictability of
outcomes" affecting the set of financial transactions and positions which
cumulatively form the firm's business .
Thus, risk includes the possibility of both pleasant surprises as well as
adverse business outcomes. Since prediction is facilitated by the availability
of information to a decision maker, RMT can be used to proactively gauge risk
in financial operations, where the outcomes of regional lending operations,
involvement in selected financial markets and instruments and positions
taken by traders are uncertain and may change from day to day.
Risk management, on the other hand, is the management of the resources
and commitments of a firm so as to maximize its value, taking into account
the impact that unpredictable outcomes or events can have on firm
performance.
Risk management activities normally involve three basic steps:

(1) exhaustive identification and classification of the risks that can impact a
firm's business outcomes;
(2) measurement of the risk associated with a set of potential events that
affect the value of the firm, in terms of the likelihood of their occurrence
and the magnitude of the expected losses they may entail;
(3) timely formulation of the actions required to bring business risks within
acceptable bounds.
The sources of risk that a firm may encounter are varied and depend on the
businesses in which it participates.
For example, a financial firm involved in trading financial instruments will face the
market risk associated with unpredictable price changes of the different financial
instruments. A second source is interest rate risk arising from interest rate
fluctuations, rendering the returns on financial assets uncertain. Interest rate risk
also poses significant financial uncertainty when there are gaps in value between
the set of claims made on a firm's assets at a specific point in time and the assets'
value when the claims are due. With a substantial gap between these values, it may
become necessary for the firm to purchase funds in the market at an unexpectedly
high cost.
Some other types of risk include credit risk and operating risk.
Credit risk is associated with defaults in repayment of loans by a borrower and
operating risk stems from frequent changes in or discontinuance of a revenue
stream against a continuing level of fixed cost expenditures in the operating
infrastructure. Being able to obtain accurate, up-to-date information is crucial in
these risk management contexts.
For example, market risk is normally measured by identifying trends of
fluctuations in interest rates, and the volatilities of financial instruments and foreign
currencies
(Volatility, here, refers to overnight price changes in an asset's value.) Volatility data
on individual financial securities are used in conjunction with data on correlations
between the prices of different instruments, and enable the potential for loss in a
portfolio to be measured quite objectively. Timely and accurate information about
interest rate fluctuations also enables risk managers to gauge the risks associated
with maintaining funding gaps. Since senior managers usually draw the line on the
maximum risk the firm is willing to undertake in any of its commitments, risk
managers and operations managers have similar incentives to take advantage of
emerging information technology-based financial management techniques that
eliminate excess risk.

Risk Management Approaches:

Goal of risk management is not to eliminate risk, but to ensure that risk remains at
a predetermined level of acceptability. Higher level of risk should provide a higher

possibility of return; otherwise , it is not worthwhile to expose the organization to

that level of risk.
Risk Avoidance: This means avoiding risk altogether. This is an extreme approach
and would result in least incentive for any activity to even take place.
Loss Control: It is the approach to reduce the possibility or quantum of a loss .For
example, to manage liquidity risk, a firm may decide to always keep a certain
portion in highly liquid assets.
Diversification: This approach follows a Do not put all your eggs in one basket
policy. This policy works well when the various business lines in an organization do
not involve a high correlation.
Risk Transfer: Under this approach,, the original party that is exposed to risk
transfers the same to another party that is willing to be exposed to that risk.
Risk Retention: Under this approach, though the firm is aware about the risk
exposure, it deliberately decides to retain it due to a very high cost of risk transfer.
Risk sharing: This approach is a combination of the earlier two approaches, where
a part of the risk is retaned and the other part is transferred out.

3. What are Interest Rate Swaps.Explain.

Basic Interest Rate Swap Mechanics

An interest rate swap is a contractual arrangement between two parties,
often referred to as counterparties. As shown in Figure 1, the counterparties
(in this example, a financial institution and an issuer) agree to exchange
payments based on a defined principal amount, for a fixed period of time.

new sources of funding themselves; rather, they convert one interest rate basis to a
different rate basis (e.g., from a floating or variable interest rate basis to a fixed
interest rate basis, or vice versa). These plain vanilla swaps are by far the most
common type of interest rate swaps.
Typically, payments made by one counterparty are based on a floating rate of
interest, such as the London Inter Bank Offered Rate (LIBOR) or the Securities
Industry and Financial Markets Association (SIFMA) Municipal Swap , while payments
made by the other counterparty are based on a fixed rate of interest, normally
expressed as The maturity, or tenor, of a fixed-to-floating interest rate swap is
usually between one and fifteen years. By convention, a fixed-rate payer is
designated as the buyer of the swap, while the floating-rate payer is the seller of
the swap. Swaps vary widely with respect to underlying asset, maturity, style, and
contingency provisions. Negotiated terms include starting and ending dates,
settlement frequency, notional amount on which swap payments are based, and
published reference rates
on which swap payments are determined.
INTEREST RATE SWAPS
Definition: Transfer of interest rate streams without transferring underlying
debt.
FIXED FOR FLOATING SWAP
Some Definitions
Notational Principal: The dollar the interest rates

apply to.
Reset Period: Period over which the coupon is fixed.
By tradition fixed rate payer has sold swap, floating rate payer has bought swap.
Example fixed for floating swap:
1.
2.
3.
4.

A pays B 8% fixed
B pays A six-month T bill rate + 2% floating
Time three years
Notational Principal one million

PERIOD
0
1
2
3
4
5
6

T-BILL RATE
4
3
4
5
7
8

B
30,000
25,000
30,000
35,000
45,000
50,000

40,000
40,000
40,000
40,000
40,000
40,000

SOME VALUATION PRINCIPALS

Ignore risk for moment .Although principal not traded equivalent to selling a fixed
for floating bond of one million since this one million cancels out.
At initiation, both sides must be happy. Thus price of fixed and floating must be
same. Since floating is at
par, rate on fixed must equal rate on three-year Treasury.
Duration fixed > Duration of floating
Therefore, if rates increase, person receiving floater better off. If rates decline, want
to receive fixed.
If no change in yield curve and upward sloping yield curve, payer of floating has
positive value over its
early life.
Equivalent Swap
1. T-bill + 1% for fixed.
2. T-bill for fixed minus 1%.
Example:
T-bill + 1% ------------>
<------------ 10%
can be valued as
T-bill ------------>
<------------ 9%

GENERAL SWAP VALUATION

1. Obtain spot rates.
2. Treat fixed rate as fixed rate coupon minus any floating spread. Discount at spots
to get present
value.
3. Since floating is par when reset treat floating as if bond maturing at reset date
and discount cash
flows at appropriate spot get present value.
Example:
1. Pay rate on six-month T-bill as of beginning of period.
2. Receive 8% (semi-annual) fixed.
3. Remaining life 18 months.
4. Notational principal 100 million.
5. Spot rates 10, 10.5, 11
6. Rate on floater 4.88

VALUE OF A SWAP
Swaps can be valued:
Difference of two bonds:
Let,

It follows that:

U -First cash flow on variable

C -Fixed cash flow
Q -Notational principal in the swap agreement
B1 -Value of floating rate bond underlying the swap
B2 -Value of fixed rate underlying the swap
V -Value of swap
LIBOR
Usually floating is pegged to LIBOR(London Interbank Offer Rate)
LIBOR has credit risk. Thus it has a spread over T-bill rates, usually about 1/2%.
Considered an AA risk.
Therefore, if initial value of swap is to be zero, the fixed rate must also exceed rate
on default-free Treasuries.

INSTITUTIONAL FACTORS
It is evident that a swap is equivalent to an exchange of bonds. Given the fact that
swaps are carried out between corporate
entities, they should display all the features of corporate bonds. However, this is
usually not the case. Litzenberger(Journal of Finance, 1992) points out that there are
three features of difference between swaps and exchange of pure corporate bonds:
1. Bid-Ask spreads are far less than on corporate bonds, and even governments in
most cases. Swap spreads are around 5 bps, the lowest in any market.
2. Swap spreads (the difference between the fixed and floating leg) do not display
the volatile cyclical behavior of corporate bond spreads.
3. The quoted swap rates do not reflect credit rating differences between
counterparties.
We call these "credit risk anomalies."
RISK AND SWAPS
1. Since principal is not swapped, maximum loss much less than on bond.
2. Therefore, if risky corporation would normally need to pay 3% over Treasuries for
swap, need to pay
much less.
3. Loss is value of swap at default.
4. If floating payer is defaulter, then fixed rate payer
Losses: if rates increased
Gains: if rates decreased
5. Note: May gain or lose with default.
6. Many swap deals have clause that swap is settled if one party's credit
downgraded.
7. Many institutions have subsidiary that in essence insures against default.
MOTIVATIONS FOR SWAP
1. Adjust duration
2. Overcome restrictions
3. Interest rate bets
4. Managing basis risk
5. Comparative advantage
a. Arbitrage
b. Differential information and restrictions
MANAGING DURATION
Why use swaps to manage Duration Risk?
1. Many institutions such as federal agencies are restricted or disallowed to trade in
futures.
2. Swap costs are low.
3. Swaps can be tailored to meet needs where futures are more standardized.

Example of Lowering Fixed Rate Costs:

Baa corporate borrows at floating rate = T-bill + 0.5%
Aaa corporate borrows at floating rate = T-bill + .25%
Quality spread for five years maturity = 1.5%
Baa corporate borrows at fixed rate = 13.0%
Aaa corporate borrows at fixed rate = 11.5%
Spread Differential = 1.25%

The swap is depicted in below Figure .

Method:
1. Aaa issues bond at 11.5%
2. Enters into swap with Baa to receive fixed 12% and pay floating
six-month T-bill rate.
Net Cost of Funds:
Aaa: T-bill - 0.5% (gains = 75 bps)
Baa: 12.5% (gains = 50 bps)
Result:
Credit Risk Arbitrage (the total gain of 125 bps is equal to the
captured spread differential)

4. Write a detailed account on Tools for Risk Management.

INTRODUCTION
Risk is a condition in which there is a possibility of an adverse deviation
from desired outcome that is expected or hoped for. In most of the risky
situations, two elements are commonly found; a. The outcome is uncertain
i.e. there is a possibility that one or other(s) may occur. Therefore,
logically there are at least two possible outcomes for a given situation. b.
Out of the possible outcomes, one is unfavourable or not liked by the
individual or the analyst. Deregulation of Markets of national economies,
growth in the international trade, and ever growing technological changes
has revolutionized the financial markets during the past four decades
world over. The resultant of this revolution is increased market volatility,
which has led to a corresponding increase in demand for risk management
products. This demand is reflected in the growth of financial derivatives
from the standardized futures and options products of the 1970s to the
wide spectrum of over-the-counter (OTC) products offered and sold in the
1990s.

II. DERIVATIVES
Derivatives are financial contracts whose value is derived from some
underlying asset. These assets can include equities and equity indices,
bonds, loans, interest rates, exchange rates, commodities, residential and
commercial mortgages, and even catastrophes like earthquakes and
hurricanes. The contracts come in many forms, but the more common
ones include options, forwards/futures and swaps. Companies are exposed
to different hazards in their normal day to day operations and when
borrowing the capital. For some of the hazards, management can achieve
security from an insurance corporation. For instance, management can
assure a plant against devastation through fire by getting a fire insurance
plan from a casualty and property insurance corporation. But Capital
market products which are available to management to secure against
different hazards are not insurable through an insurance corporation.
These hazards include hazards connected with changes in the price of an
input, a reduction in price of a commodity the company sells, an increase
in the cost of borrowing investments, and an unfavourable movement of
exchange rate (Jana, 2010). The tools that can be applied to present these
securities are identified as derivative tools, so called because they obtain
their importance from whatever the agreement is based on. These tools
comprise
futures
agreements,
forward
agreements,
alternative
agreements, swap contracts, and floor and cap contracts. It is not an
exaggeration to state that a considerable portion of financial innovation
over the last 40 years has come from the emergence of derivative
markets. EXCHANGE TRADED derivatives are dominated by equity
derivatives and commodity derivatives. OTC derivatives are mainly in
fixed income and currencies.
The benefits of derivatives are threefold: (i) risk management, (ii) price
discovery, and (iii) enhancement of liquidity.

Benefits:
The primary use of derivatives is to hedge ones positions i.e., to reduce
or eliminate the risk inherent in commodities, foreign currencies and
financial assets. Farmers who want to guarantee the prices of their future
crop can sell them at any time in the futures or forward market. Exporters,
exposed to foreign exchange risk, can reduce their risk using derivatives
(forward, futures, and options). Pension funds who invest in securities can
avoid disastrous consequences by buying insurance in the form of put
options. The risk management benefits of derivatives are not limited to
hedging ones exposure to risk but to a whole spectrum of risk-return
combinations which can be achieved using options. For example, these
features allow one to protect themselves in extremely volatile times like
we are witnessing now. Another important benefit is the information that
can be extracted from various derivatives. Price discovery is one aspect
of it. Some examples include the ABX indices (i.e., portfolio of
Collateralized Debt Obligations (CDOs) of subprime mortgages) which
were one of the first instruments to provide information to the market on
the deteriorating subprime securitization market1 in the USA; exchange
traded funds (i.e., ETFs) which provide information on the prices of
securities ahead of the stale indexes (e.g., SPY vs. SPX); and option prices
on individual equities which reveal private information more quickly into
the market2 . Derivatives also allow market participants to extract forward
looking, as opposed to historical, information. For example, it is
commonplace now to back out volatility, skewness (e.g., crash risk) and
kurtosis (e.g., fat tails) of an underlying asset from option prices on that
asset. Such information is used, among others, by central banks in making
policy decisions, investors for risk and return decisions on their portfolios
and corporations for managing financial risk. Another example is the
expected Central bank rate decision obtained from Central Bank Funds
Futures. An additional positive advantage is the enhancement of liquidity.
Adding derivatives to an underlying market has two effects; (i) it brings
to the market additional players who use the derivatives as a leveraged
substitute to trading the underlying, and (ii) derivatives provide a hedge
to market makers allowing a reduction in transactions costs through a
lower bid-ask rate. By and large, spot markets with derivatives have more
liquidity and thus lower transaction costs than markets without
derivatives. Given the above seemingly important benefits, why are
derivatives, and especially credit derivatives, viewed so negatively in the
current financial crisis? The problem is not with the derivatives as an
instrument, but with (i) the way they were traded and cleared, and (ii) how
they were used by some financial institutions to increase their exposure to
certain asset classes.

III. RISK MANAGEMENT

Risk management is one of the responsibilities of management as these

risk management shares many features of common management, and yet
is unique in several important respects (Barry, Donald and Bankim, 2003).
Risk management is the human performance which incorporates
identification of hazard, assessment of risk, improving plans to control it,
and improvement of risk applying managerial resources (Robert and
James, 2009). Risk management is demonstrated as the method of
organizing, planning, directing and managing the activities and resources
of a company to reduce the unfavorable impact of possible losses at the
minimum probable costs.

IV. FINANCIAL RISK

Risk is a possibility in finance, that returns of investment will not be same
as anticipated. This shows the probability of losing some or the entire real
assets. It is normally estimated through measuring the deviations from the
historical returns or normal returns of a particular investment. An
important view in economics is the relation between return and risk. The
bigger the amount of hazard that a financier is eager to take on, the larger
the possible return. The motive for this is that financers must be rewarded
for taking on extra hazard (Patrick and Martin, 2005). Financial risk is
normally described as the unanticipated volatility or variability of returns,
and therefore contains both possible worse than anticipated with excellent
than anticipated returns. An enquiry into the reason for major losses
would show that the losses were not due to derivatives, but the improper
use of them by management that was either ignorant about the risks
associated with using derivative instruments or management that sought
to use them in a speculative manner rather than a means for managing
risk. Another term for speculative purposes is trading purposes. The
important reason of these devices is to provide firm promises to charges
for futures charges for future date for giving protection against the
harmful events in future charges, to reduce the quantum of economic
hazards. Not only this, they further provide more opportunities to get
profit from earnings for those entrepreneurs who are prepared to take
higher risks. In other words, these devices really help to move the risk
from those who desire to bypass it to those who are ready to accept the
similar. Currently, the economic derivatives have become progressively
well liked and most routinelyutilised in the world of economics. This has
developed with so phenomenal pace all over the world that currently it is
identified as the derivatives rebellion.

V. FINANCIAL DERIVATIVES
Financial derivatives are devices that permit value swaps founded on preexisting actions. Normally, the proprietor of the genuine supply goes into

an affirmation with somebody who will be eager to purchase that supply

at an established cost at some time in the future. The last cited is the
most widespread pattern of preparation. Though, other affirmations in the
market manage exist. The reason of an economic derivative is to give
proprietor or buyer influence power of a large supply utilising negligible
investment (Robert and James, 2009). On the other hand, occasionally,
the asserted allowance selected for the economic derivative can be
incorrect i.e. the future can work contrary to the supply owner. In these
situations, it would have been sensible to manage with payments other
than through the implementation of derivatives.

Definition
Derivatives are specific types of instruments that derive their value over time from the
performance of an underlying asset: eg equities, bonds, commodities.
A derivative is traded between two parties who are referred to as the counterparties. These
counterparties are subject to a pre-agreed set of terms and conditions that determine their
rights and obligations.
Derivatives can be traded on or off an exchange and are known as:
Exchange-Traded Derivatives (ETDs): Standardised contracts traded on a recognised
exchange, with the counterparties being the holder and the exchange. The contract terms
are non-negotiable and their prices are publicly available.
or
Over-the-Counter Derivatives (OTCs): Bespoke contracts traded off-exchange with
specific terms and conditions determined and agreed by the buyer and seller
(counterparties). As a result OTC derivatives are more illiquid, eg forward contracts and
swaps.

Commonly used derivatives and their uses

The most common types of derivatives are options, futures, forwards, swaps and
swaptions.
Options:
Exchange-traded options are standardised contracts whereby one party has a right to
purchase something at a pre-agreed strike price at some point in the future. The right,
however, is not an obligation as the buyer can allow the contract to expire and walk away.
The cost of buying an option is the sellers premium which the buyer must pay to obtain the
option right. There are two types of option contracts that can be either bought or sold:
Call A buyer of a call option has the right but not the obligation to buy the asset at the
strike price (price paid) at a future date. A seller has the obligation to sell the asset at the
strike price if the buyer exercises the option.
Put A buyer of a put option has the right, but not the obligation, to sell the asset at the
strike price at a future date. A seller has the obligation to repurchase the asset at the strike
price if the buyer exercises the option.
Futures:
Futures are exchange-traded standard contracts for a pre-determined asset to be delivered
at a pre-agreed point in the future at a price agreed today. The buyer makes margin
payments reflecting the value of the transaction. The buyer is said to have gone long and
the seller to have gone short. Counterparties can exit a commitment by taking an equal but
offsetting position with the exchange, so that the net position is nil and the only delivery will
be a cash flow for profit or loss. Futures coverage includes currencies, bonds, agricultural
and other commodities such as gold. An example would be to buy 10 EUR/USD December
contracts each with a nominal of EUR 125,000 to gain future delivery of EUR 1.25 million at a
pre-agreed exchange rate.5

Forwards:
Forwards are non-standardised contracts between two parties to buy or sell an asset at a
specified future time at a price agreed today. For example, pension funds commonly use
foreign exchange forwards to reduce FX risk when overseas currency positions are required
at known future dates. As the contracts are bespoke they can be for non-standardised
amounts and dates, eg delivery of EUR 23,967 against payment of USD 32,372 on 16
January 2014.
Swaps:
Swaps are agreements to exchange one series of future cash flows for another. Although the
underlying reference assets can be different, eg equity or interest rate, the value of the
underlying asset will characteristically be taken from a publicly available price source. For
example, under an equity swap the amount that is paid or received will be the difference
between the equity price at the start and end date of the contract.
Swaptions:
These are non-standard contracts giving the owner the right but not the obligation to enter
into an underlying swap. The most common swaptions traded are those dependent on
interest rates which allow funds to create bespoke protection. Contracts can be
preconfigured to provide both upside and downside protection if an event occurs. For
example, a party can purchase a swaption to protect itself from the 10-year interest rate
swap rate going below 1% in 3 months time.

Market risk

Market risk refers to the sensitivity of an asset or portfolio to overall market price
movements such as interest rates, inflation, equities, currency and property. Pension funds
are heavily exposed to interest and inflation rate risks as these determine the present value
of the schemes liabilities; typically these risks are referred to as unrewarded risks as these
are intrinsic to the liabilities. While market risk cannot be completely removed by
diversification, it can be reduced by hedging. The use of interest and inflation rate swaps
can produce offsetting positions whereby the risks are hedged.
Pension funds can access interest rate and inflation hedges through liability-driven
investment funds (LDI) or by using derivatives directly. Typically derivatives contracts also
carry collateral requirements to manage counterparty exposure (see Counterparty Risk on
page 13).

Example Interest rate swap

Ordinarily when interest rates rise, the discount rate used in calculating the net present
value (NPV) of liabilities rises, so the NPV of those liabilities is reduced and the funds
funding ratio is improved. However, the opposite is also true of a decrease in rates, whereby
the NPV of liabilities increases and the pension schemes funding deteriorates.
Swaps can involve a scheme swapping either a fixed or variable rate payment.
In the following example, Scheme A wishes to reduce its exposure to interest rate sensitivity
and has entered into an interest rate swap contract whereby it has agreed to pay a variable
rate of interest on a nominal amount in exchange for a fixed rate of interest on the same
nominal. With such a position, the value of both scheme assets and liabilities is either
positively or negatively affected. The net position is that the funding status remains
unmoved and thereby the position is hedged.
Scheme A swaps a variable rate payment in exchange for a fixed one. There are two legs to
the contract, one fixed and one floating (see diagram below).
Under normal circumstances the present value of the future payments under each leg of the
swap would be a similar amount on initiation; but over time market movement is likely to
vary from expectation. However, if set up correctly the net position of the funding status will
remain unmoved and thereby the position is hedged.

Example Inflation rate swap

Inflation is one of the main risks that pension schemes are exposed to as typically schemes
liabilities may be linked to inflation. Therefore, high inflation has a negative impact on the
NPV of a scheme as liability values are higher and may create additional funding requests
for the corporate sponsor. Inflation rate swaps can be used to reduce inflation risk. Similar to
an interest rate swap there are two flows and payments are made between the two
counterparties.
In this example, Scheme A swaps a variable rate payment for a fixed one, with changes in
the variable payment dependent upon changes in an inflation rate calculated on a nominal
amount. In this example, the scheme funding status (net ratio of assets to liabilities) will
remain unaffected and thereby the position is hedged.

Currently, the deepest market for inflation swaps references the Retail Price Index (RPI).
Certain pension schemes liabilities may reference the Consumer Price Index (CPI). Schemes
should consider the trade-off between liquidity and basis risk (the difference between RPI
and CPI) when looking to hedge inflation risk.

Market risk methodologies

When establishing a derivatives overlay, it is essential for pension schemes to measure their
exposure to market risk and leverage. In this section, we review some of the main market
risk and leverage methodologies, their application, interpretation and benefits.

Commitment approach
The commitment approach is a standard methodology used to calculate the gross notional
exposure and global exposure (net leverage/gearing) arising from a portfolios
derivatives. The commitment approach is referenced in detail in the guidelines issued by the
European Securities and Markets Authority (ESMA) for UCITS funds on 28 July 2010. These
guidelines build on standard market methodologies and practices to calculate the underlying
exposure of derivative instruments and a measurement of global exposure. They are a
valuable reference source for UCITS and non-UCITS practitioners.
The commitment approach is a measure of leverage and does not fully reflect the market
risk arising from derivatives. Other measures including qualitative assessment should also
be performed to ensure the schemes market risk is adequately identified.
Gross notional exposure:
This metric represents the absolute value of the sum of the values of individual derivative
instruments. Gross notional exposure reports usually show the split between long and short
derivative values as well as the gross absolute value. The calculation of exposure is based
on an exact conversion of the financial derivative into the market value of an equivalent
position in the underlying asset of that derivative. For example, for an Equity Futures
contract the notional exposure is equal to the following:
Number of contracts * notional contract size * market price of underlying equity
share.
Global exposure:
The global exposure is the absolute value of the notional exposure of each individual
derivative after applying any hedging and netting benefits of longs and shorts. It is a metric
reflecting the net leverage and provides a better understanding of the net derivative
exposure arising from derivatives in the portfolio compared to the gross notional exposure
metric.

Global exposure can be calculated by carrying out the following seven steps:
Step 1
Select all derivative instruments within the fund.
Step 2
Calculate the commitment of each derivative instrument.
Step 3
Apply netting and/or hedging logic to reduce commitment value.
Step 4
Absolute the value of any derivative instrument not used in the netting/hedging.
Step 5
For any derivative used within the netting/hedging; absolute any uncovered values that
remain.
Step 6
Add the values from steps 4 and 5.
Step 7
Divide the results from step 6 by the total portfolio value to represent the global exposure
as a percentage.
Netting:
Netting is the combinations of trades on financial derivative instruments and/or security
positions which refer to the same underlying asset, irrespective of the contracts due date.
Trades on financial derivative instruments and/or security positions are concluded with the
sole aim of eliminating the risks linked to positions taken through the other financial
derivative instruments and/or security.
Hedging:
Hedging refers to combinations of trades on financial derivative instruments and/or security
positions which do not necessarily refer to the same underlying asset. Trades on these
instruments/positions are concluded with the sole aim of offsetting risks linked to positions
taken through other instruments/positions.

Value-at-Risk
Value-at-Risk (VaR) is a commonly used measure of risk. As a single metric, it provides a
single consolidated view which incorporates the schemes exposure to risk sensitivities.
ESMA recommends that UCITS funds with more complex investment strategies use the
Value-at-Risk approach as a complement to the commitment approach.
Definition: VaR calculates an expected loss amount that may not be exceeded at a
specified confidence interval over a given holding period, assuming normal market
conditions.
Interpretation: The higher the portfolios VaR, the greater its expected loss and exposure
to market risks.
Benefit: VaR is a composite risk measure that incorporates interest rate, FX, credit,
inflation, equity risks etc. into one figure. VaR gives a consolidated view of different risks in a
portfolio.
VaR methodologies common approaches
There are three commonly used methodologies to calculate VaR each is valid in its own
right but not all measures are appropriate for a given portfolio. Validity depends on where
the assets are held, processing power and price. Whilst common assets such as equities and
bonds tend to be linear in their outcomes, this is not necessarily the case for all derivatives;
eg an option may give protection if the underlying asset price goes down but not up (or vice
versa), so the payoff profile is skewed one way or another. A normal distribution of outcomes
is therefore not always valid where derivatives are held.
Parametric:
This approach calculates VaR typically assuming returns are normally distributed
Estimates VaR direct from the standard deviation of the portfolio returns
Easy to calculate and understand
Historical simulation:
This approach calculates VaR from a distribution of historical returns
Can only reflect asset sensitivities to events captured in the time horizon used
Easy to calculate and understand
Monte Carlo simulation:
This approach calculates VaR from a distribution constructed from random outcomes
Can be difficult to explain as it uses sensitivities to re-price assets via a model
Computer-intensive as normally thousands of scenarios are run with each constituent asset
requiring repricing per each scenario
Accommodates assets with non-linear pay-offs.

Complementary metrics

Theres also a combination of complementary VaR and non-VaR metrics which can give a
more indepth understanding of a situation.
Active VaR:
Definition: For a pension scheme this is the difference between the assets and liabilities. If
a scheme is perfectly immunised active VaR will be nil.
Interpretation: The higher the active VaR of a portfolio, the greater the schemes exposure
to market risks.
Benefit: Active VaR on a discrete time horizon basis indicates where changes are required
to the investment policy or the assets held.

 Conditional VaR (CVaR):

Definition: This averages all the expected losses greater than VaR, also known as expected
shortfall or tail loss.
Interpretation: If VaR is calculated at a 99% confidence level, CVaR averages the worst 1%
expected losses.
Benefit: In one comparable metric, this indicates the wider exposure not contained in VaR.
This is very useful where there is a high exposure to derivatives as the distribution may be
highly skewed.
Marginal VaR (MVaR):
Definition: This is a measure of the change in VaR at the aggregation level when an
instruments position is increased by one percent or unit.
Interpretation: It helps optimise the risk/return profile of a portfolio.
Benefit: An indicator of which assets or sectors provide the most or least level of exposure.
As such it can assist in identifying any possible corrective changes required.
Partial VaR (PVaR):
Definition: A measure of the change in VaR at the aggregation level when an instruments
position is completely removed.
Interpretation: This helps clients understand the contribution to aggregated VaR.
Benefit: Since assets influence each other (covariance), removing an individual asset can
have a disproportionate change in the level of risk. This identifies key contributors.
Other metrics that can be used to complement VaR metrics include sensitivity or scenariobased analysis:
PV01:
Definition: A measure of sensitivity to a 1bp (basis point) change in interest rates. This can
be shown for scheme assets, liabilities, and also the difference between the two which is
known as active PV01. The outcomes may be positive or negative reflecting the percentage
change in scheme value for say a 1bp or a 50bp rise or fall in interest rates.
Interpretation: The higher the PV01, the greater the sensitivity to a change in interest
rates. An immunisation policy would attempt to have a zero active PV01.
Benefit: This metric is used by strategists to indicate immunisation completeness. It can
also help in detailing at which point rebalancing of assets and hedges may be required.
IE01:
Definition: A measure of sensitivity to a 1bp change in inflation. This can be shown for
scheme assets, liabilities, and also the difference between the two which is known as active
IE01. The outcomes may be positive or negative reflecting the percentage change in the
schemes value for say a 1bp or a 50bp rise or fall in inflation.

Interpretation: The higher the IE01, the greater is the sensitivity to a change in inflation.
An immunisation policy would attempt to have a zero active IE01.
Benefit: This metric indicates immunisation completeness and can assist in detailing at
which time rebalancing of assets and hedges may be required.
Reporting example 1 Active summary (assets less liabilities):
Scheme immunisation targeting compares assets to liabilities. Perfect immunisation is where
future asset value is the same as future liability at each pensioner payment point. An active
position occurs when the values dont perfectly match, thereby the closer any active metric
is to zero, the more effective the immunisation policy.
The following example shows an imperfectly immunised scheme, with an active VaR at
4.52% and a confidence level of 99%.
This means:
There is a one percent chance that the schemes assets could lose more than 4.52% value
greater than the liabilities over a 1 month period
Active PV01 is positive, so the schemes asset value would change 0.16% greater than that
of liabilities for a 1bp change in interest rates, thereby assets are more sensitive to interest
rate changes than liabilities
As active IE01 is positive, for a 1bp point change in inflation the asset value would change
0.09% more than the liabilities. Therefore, the assets are more sensitive to changes in
inflation than the liabilities
Reporting example 2 Immunisation effectiveness:
A common immunization policy is to match the durations of assets and liabilities at each
time period when liability payment is expected. The following chart shows active duration
over the schemes time horizon. If the scheme is perfectly immunized, the assets would fund
the liabilities in each time period. However in this example imperfect immunization exists.
This chart shows the risk points and exactly where rebalancing action is required. A duration
mismatch will also be reflected in PV01 (interest rate sensitivity) and IE01 (inflation rate
sensitivity) active positions at each time point. Similar tables can be constructed for larger
shifts (eg 10bp, 50bp and 100bp).

Counterparty risk
In addition to market risk, derivatives carry counterparty credit risk. Counterparty risk arises
when one of the parties defaults, resulting in a replacement risk for the non-defaulting party.
Replacement risk can be broken down into:
Mark-to-market exposure: The close out process may result in realised mark-to-market
exposure on the underlying contract
Liquidity risk: Sourcing sufficient liquidity in the market (notional/maturity) to replace the
required position that has been closed out following the counterpartys default
Operational risk: Managing the close-out of a portfolio of positions, notifying the
counterparty that an event of default has occurred, replacing the transactions in the market,

accurately margining transactions, managing any on-going valuation disputes, meeting

required intra-day settlements
Legal risk: Enforceability of netting/collateral enforcement arrangements
Collateral risk: Collateral posted may be ten-year government bonds. However, on
default there may be a requirement to reinvest cash into new assets. Theres also the risk
that the haircuts on the collateral are insufficient or that the collateral is too closely
correlated with the risk of the counterparty (eg systemically important bank posting its
governments bond)
Settlement risk: The intra-day exposure to a counterparty, arising from transfers of cash
flows under a derivative transaction or returns of collateral amounts following payments
under a derivative contract (eg cross-currency swaps, option purchases, etc.)
As the use of derivatives has grown, systems and methodologies to monitor and mitigate
counterparty risk have become more sophisticated. Regulators have also been enhancing
the accounting standards (eg IFRS 13) and capital frameworks to capture counterparty risk
(Basel II, Basel III, Solvency II).

Counterparty risk methodologies

Quantifying the exposure
In this section, we explore the current approaches that market counterparties are using to
monitor and manage derivatives exposure. These approaches primarily focus on the markto-market component of replacement risk.
Derivative contracts are dynamic in nature and can therefore give rise to either an asset or a
liability for a counterparty (depending on market movements). The following metrics can be
used to monitor and measure counterparty exposure:
Notional of contracts
Current mark-to-market
Expected exposure
Stressed future potential exposure
Notional of contracts: As a metric, this provides information around the total size of a
product with a counterparty. Unlike bonds and loans, the notional of a derivative does not
reflect the actual risk. Furthermore, it is not straightforward as to how best to net positions
where long and short positions are entered into with different maturities, coupon details,
options, etc.

Current mark-to-market: This is a snapshot of the current exposure to a counterparty

typically adjusted to reflect any netting (eg ISDA agreements) and collateral arrangements.
This provides more information than the notional amount of derivatives in question.
However, it is still limited in its information, particularly when the forward mark-to-market is
expected to change (eg based on the shape of the interest rate yield curve). This metric can
be enhanced by incorporating a sense of the potential future exposure using a specific
percentage of the notional of each transaction (add-on factor) based on a grid for each
underlying asset class and maturity. An example of this can be found in the Basel II banking
capital rules.

Note: Steps 2 and 3 are optional and subject to the conditions being met with regards to
enforceable netting arrangements being in place and eligibility of collateral.
Counterparty credit risk = (Current net exposure + Potential future exposure) collateral

Potential Future Exposure (PFE) is calculated by multiplying the notional values of the
contracts with a fixed percentage which is based on the PFE Add-on Factor.
PFE Add-on Factor is based on the asset class and on the remaining maturity of the contract.

Expected exposure: This represents the expected positive mark-to-market profile of a

swap or portfolio of transactions reflecting any netting and collateral arrangements at
different points in the future. Expected exposure is typically calculated as the average of
potential mark-to-market paths which are in-the-money (out-of-the-money paths are set at 0
for the purposes of computing the average). The paths can be generated using a MonteCarlo simulation using implied market volatilities and correlation parameters.
The chart below illustrates the exposure on a 5 year Swap as a % of Notional.
As an example, if interest rates were to reduce by 0.5% at the end of year 1, then in the
event of a default the replacement cost for the counterparty receiving the fixed rate will be
equal to the following:
0.5% (rate change) * 4 (years) = 2% of Notional.

Stressed future potential exposure: This is typically a high percentile of the distribution
of potential in-the-money paths for the portfolio of derivatives. This metric is sometimes
referred to as a peak exposure measure. The paths used in this calculation can be generated
using a Monte Carlo simulation in a similar way to the expected exposure and then further
enhanced by using stressed parameters (eg worst case historic volatilities/correlation
parameters). Examples of high percentiles used for measuring the exposure include 95%,
97.5%, 99% or 99.5%.

Managing the exposure

Risk limits
Counterparty risk can be managed by constructing risk limits for each counterparty based
on:
Counterparty rating, market capitalisation, country of incorporation
Maturity bucket (1 day, 1 week, 30 days, 1 year out to 50 years)
Exposure metrics outlined above (including and excluding the benefit of collateral and
risk mitigation techniques)

Product

type

(equities,

FX,

interest

rate,

inflation,

etc.)

Collateral arrangements and collateral management:

Collateral has historically been used to facilitate trade between two parties by providing
security against the possibility of default of a counterparty. The main intention of using
collateral has been to manage counterparty credit exposure created by bilateral trading.
Over the last decade, OTC derivative exposure has been more formally managed via Credit
Support Annexes (CSAs) under International Swap and Derivatives Association Master
Agreements (ISDAs) setting out collateral arrangements. Active management of
counterparty risk by market participants, particularly buy-side firms, has resulted in larger
amounts of collateral being demanded and more frequent movements between
counterparties.
Credit support agreements (CSAs) are typically used for derivative transactions as a way of
reducing the mark-to-market exposure to a counterparty. Under a CSA the counterparties
agree to collateralise the net mark-to-market exposure of the portfolio with a defined pool of
eligible assets (eg cash, government bonds). The collateral is transferred to the other party
when the portfolio of transactions under the respective CSA is a net negative amount for the
transferring party.
Collateral arrangements mitigate credit risk by transforming it into legal and operational
risk, subject to:
Legal enforceability of collateral arrangements
Operational capabilities to margin derivative portfolios daily, subject to minimum transfer
amounts, thresholds, etc.
Liquidity risk arising on ability to meet daily margin calls
Collateral replacement risk following a close out event
Regulations such as Dodd-Frank, EMIR, IOSCO, MiFID /MIFIR and Basel III are designed to
create (amongst other things) greater transparency and appropriate capitalisation of
derivative instruments. They will also bring greater complexity in collateral processes as OTC
clearing brokers are introduced, collateral eligibility becomes more granular and segregation
of collateral is considered across both cleared and non-cleared instruments. Even where
mandatory clearing is not applicable, reporting and risk mitigation requirements may apply.
For many participants, increased costs are also a key concern, which in turn is placing
greater focus on the collateral management process. A key focus across all organisations is
to employ efficient processes that identify and deploy the cheapest assets to deliver as
collateral.

Active management
OTC derivatives can move dynamically within volatile markets, creating the potential for predefined risk limits to be breached following sizeable market movements. To address this,
active management of counterparty risk may be necessary by:
Re-couponing/resetting the mark-to-market of the derivative
Unwinding positions based on certain market movements
Transfer of positions from over-threshold names to third parties (novation) where risk
limits are being under-utilised
Hedging the exposure using credit derivatives with a third party
Incorporating a credit support annex (CSA) with daily settlements, thresholds, minimum
transfer amounts, independent amounts
Given the bilateral nature of derivatives contracts in many of the cases above, consent from
the over-threshold counterparty may be required to effect these actions.

Further areas of risk analysis around derivatives

Additional considerations for counterparty risk management include:
Liquidity implications on portfolio allocations of using derivative transactions and
different eligible assets in collateral agreements
Transfer pricing of the cost of credit and liquidity risk in derivative contracts into
strategic asset allocations
Hedging tools for derivative exposure
Valuation implications of derivatives of collateral arrangements, clearing, credit and
capital19

Summary
In summary, pension trustees continue to have considerable scope regarding how they
monitor and manage their pension schemes risk. At the same time, derivative and portfolio
structuring are becoming increasingly complex which in turn requires more sophisticated
risk management and reporting. This makes it even more important for pension schemes to
properly understand, monitor and manage their risk exposures.
Whilst VaR remains an important metric for measuring market risk exposure, there are
limitations with this measure. Regulators are increasingly recommending a broader range of
risk metrics to evaluate risk exposure. Ultimately, each pension scheme needs to adopt the
best combination of risk metrics for its unique asset/liability, funding and risk profile.

Key considerations associated with applying derivatives

1) Identifying the right overlay strategy

Derivatives can be used for risk reduction and efficient portfolio management. The key
starting point is to establish an appropriate overlay strategy defining its objectives, the
associated cost and benefits as well as key risks.
2) Establishing robust operational procedures for managing an overlay strategy
Pension schemes need to ensure appropriate and robust processes are in place when using
derivatives overlays, which should include amongst other aspects:
(i) Creating an appropriate governance and internal risk reporting framework
(ii) Pricing, executing and booking the transactions
(iii) Measuring and reporting risk arising from the derivatives overlay and its effect on the
pension schemes strategic asset and liability portfolios and liquidity profile
(iv) Managing the operational aspects of the derivatives (eg collateral transfers)
(v) Monitoring of additional risks (eg counterparty risk limits)
(vi) Complying with regulatory requirements (eg potential future EMIR clearing implications)
3) Identifying risk limitations
There is a wide range of trade-offs involved in risk-managing a pension scheme as in
practice it is not possible to perfectly manage a risk. Derivatives provide a tool for managing
risks and achieving certain financial objectives; however, as with any risk management
decision, they may convert a first order risk (eg interest rate risk) into other second order
risks (eg liquidity risk, rebalancing risk, counterparty risk etc). When using derivatives,
appropriate analysis of these limitations needs to be carried out.

VI. THE FUNCTIONS OF FINANCIAL DERIVATIVES

Financial derivatives have two important functions. They are: Hedging
Speculation Financial derivatives are instrumental in the hedging method
because through them, groups can exchange risk. Generally, this is likely
through the implementation of an inherent asset or a supply that really
exists. The inherent asset devotes one group the opening to protect
themselves contrary to a promise risk in the future whereas the other
party furthermore does the similar. Taking the example of an electrical
power generator and an electrical power distributor; the constructor
cannot be certain about the future cost of his service and is thus at risk in
the future (Patrick and Martin, 2005). On the other hand, the electrical
power vendor cannot be certain about the accessibility of electricity. If
these two groups depart their uncertainties to possibility, then they could
be susceptible in the future. Although through economic derivatives, it is
likely for the electrical power constructor to be certain about the method

which he will obtain for his services from the electrical power vendor
therefore reducing his hazard. On the other hand, the electrical power
vendor is currently certain of the accessibility of electrical power through
the economic derivative. Both groups have reduced their risk. Derivatives
are furthermore instrumental in the method of hedging because of the
detail that they are rather straightforward in themselves and manage
need not elaborate formulations of balance sheet. Derivative goods can be
set up despite of the detail that those goods manage not really exist.
Normally, in the economic market, derivatives are got from living trading
indices (Barry, Donald and Bankim, 2003). This permits an individual or an
enterprise the opening of commanding a very large buying into with only
a little buying into (this is generally identified the choice margin or
premium). Through this conduit of buying into, traders have the opening
of hedging themselves contrary to the risk of really buying the future
supply utilising their genuine value. The second ascribe is to consider their
function in speculation. Study reveals that large number of traders enlist
in speculative dealing of this economic derivatives. Different organisations
accept as factual that it can be likely to set up a tendency of how a
specific pattern of protection will act in the future. Financers generally call
this type of buying as directional playing. It must be documented that
speculative dealing is very complex and if one deals badly, it can lead to
gigantic losses. There are several matters that financers require to
address as managing speculative dealing, they require having oversight
on future eventualities, they require to workout excellent judgment on
probable economic approach (Christopher, 2004). Derivatives authorize
traders to be adept to obtain payoffs without inevitably putting in too
much buying into in the system. Through this conduit of business, it is
likely for exact persons to deal supply that they should manage not to
have. In spite of all these advantages, economic derivative furthermore
arrive with their individual risks (Barry, Donald and Bankim, 2003). For
example, since derivatives permit establishment of market cost through
provisional entails, this can be upsetting to the market. Economic
derivatives can assist in the direction of instability of pre-existing stock.
Derivatives proceed a long way in reducing the rate of instability in any
given market. For example, a study undertook through the University of
Pennsylvania throughout 2000 to 2001 discovered that most businesses
use economic derivatives to reduce risk or hedge their risk. In this study, it
was furthermore discovered that 22 per cent of the companies utilising
economic derivatives organise to decrease their concern rate exposure
through close to 22 per cent (Christopher, 2004). Moreover, five per cent
of the businesses decreased the instability of their supply comes back
through five percent. A great percentage of the companies utilised were
fond of utilising economic derivatives to reduce their foreign exchange
hazards. It was discovered that this specific responsibility was decreased
through eleven per cent with this approach.

VII. CRITICISM
Financial derivatives permit financers to invest in large allowances of
securities with negligible investment. Whereas this environment can be
regarded as a benefit, in certain examples it can become a gigantic loss.
For example, it gives a large estimated worth imitating a situation where
the respective shareholder will not be adept to reimburse for loses. One of
the leading investors in the world, Warren Buffet claimed that economic
derivatives are so unsafe that they can even be origin for financial
disasters (Stephen, 2007). He clarified this claim by saying that numerous
persons turn to the economic derivatives market to direct them on future
funding rather than of observing at the genuine market. This can finally
lead to market distortions and can be extended to other parties
connecting in investments thus financial position of a country can be
harshly obstructed. Financial derivatives can furthermore be awkward in
that they give enormous risk to financers who manage them are not
understand their way in this pattern of investment. The similar features
which they were presumed to eradicate can become even more additional
risk. Normally, inexperienced enterprise individuals can be attracted to
economic derivatives because they provide them the opening to get
heavy returns for little investments (Robert and James, 2009). As a result,
this feature can appeal to large number of financers even when those
financers have negligible know-how in that pattern of business. The end
result of this is that need of market information and little knowledge can
lead to bad economic decisions. How managers of economic risk can
apply futures and choices to hedge economic risks? Futures can be
characterised as types of economic derivatives which need one party to
buy a granted protection at a particular designated day in the future. One
more style of observing at it is through recounting futures as economic
devices that need one party to deal their product to another group at a
certain repaired cost throughout a set designated day in the future. With
this pattern of fee, one can be adept to hedge their enterprises contrary
to certain hazards (Gary. et al, 2001). Possibilities conversely mention to
economic derivatives that present holders the alternative of buying a
repaired allowance of protection or supply at a certain cost throughout a
particular designated day in the future. Moreover, choices can permit
financers to deal an identified amount of supply at a particular cost at an
exact time in the future. Generally, choices need a pre-existing allowance
of supply generally identified the choice premium. Possibilities are helpful
as an entails oof hedging enterprises contrary to hazard because they
influence resources.

VIII. CONCLUSION
Business is all about taking risk. What matters is how the risk is handled.
Often, there are
so many permutations of risks that can affect the business that it will take
away most of the profits if one were to reduce/eliminate all of them.
Ultimately, it is the organizational cultural and its appetite for risks that

will determine risk management policies. Risk management is an

important part of corporate planning; it envisages a systematic approach
for identification, measurement and control of a variety of risks faced by
an organization. The top management is also becoming more cost
conscious and more aware of how should risk management helps to
minimize expenses. The organizations are learning to cope with a rapidly
changing environment with hedging strategies which provide buffers to
the bottom line. Thus the organizations are having many strategies to
focus on the managing on the risk that are facing in every way of its
business life.