An Assignment On Practical Application With Reference to RISK MANAGEMENT

Study Of
RISKS

IN DERIVATIVE TRADING

Faculty Guide: Prof. Pinakin Jaiswal

Submitted By: Pankaj Polara Brinda Mapara - 23 - 24

Section: FINANCE-A M.B.A II, SEMESTER - 4

Dr. J. K. Patel Institute of Management Vadodara Parul Group of Institutes Affiliated to Gujarat Technological University

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Derivative
A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties. A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

Derivatives Basics
Derivatives are financial instruments whose price is determined by some underlying variables. Derivatives can be traded directly between the two parties as well as through exchanges. There are different types of derivatives based on the type of assets that it deals in such as commodity, equity, bond, interest rate, index and so on. Mainly there are four types of derivatives that are traded Future, Forward, Options and Swaps. In case of stock market derivative trading essentially means trading in future contracts and options. In derivative trading, stocks are bought in the form of contracts and in a lot. The biggest advantage of derivative trading is that you can buy huge amount of stock by paying only a part of the total value of the stock. As in derivative trading you have to buy the stocks in a lot the price of the lot is relatively lower than the total amount stock you get. So,
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this means you have a chance of making profit even by investing a comparatively less money. Derivative trading also lets you short sell the stocks. That means you can sell the stocks even before you actually own them. This is beneficial when you have an idea that the price of a particular stock is going to reduce. In derivative trading you can first sell the stock at a higher price and then buy the equal number of stocks when the price has gone down. In that way you can make profit in derivative trading even if the price is going down. In derivative trading the brokerage is relatively lower than the cash segment. If you consider the number of stock that you purchase in the form of future contracts then you will find that you have to pay less brokerage compared to the cash segment. While dealing in derivatives the only thing that you need to be careful is the expiry dates of the contracts.

Types
OTC and exchange-traded
In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market: Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options - and other exotic derivatives - are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$708 trillion (as of June 2011). Of this total notional amount, 67% are interest rate contracts, 8% are

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credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.

Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individuals trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges. Also, warrants (or "rights") may be listed on equity exchanges. Performance Rights, Cash xPRTs and various other instruments that essentially consist of a complex set of options bundled into a simple package are routinely listed on equity exchanges. Like other derivatives, these publicly traded derivatives provide investors access to risk/reward and volatility characteristics that, while related to an underlying commodity, nonetheless are distinctive.

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Economic function of the derivative market

Some of the salient economic functions of the derivative market include: Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices. The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite for risk. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk. As supervision, investigation of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment. A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for new Entrepreneurs. The derivatives market has a history of alluring many optimistic, imaginative and well educated people with an entrepreneurial outlook, the benefits of which are colossal.

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The following reasons provide information on why it may be a good idea to begin derivatives trading. 1. Less Risk than other Trades When you trade in derivatives, you are not purchasing the underlying product or buying into the company, although in some cases you are agreeing to purchase assets in the future, also known as futures trading. Instead, your risk is on the performance. There are two main types of derivatives: futures and options, which allow someone the option to buy or sell at a prearranged price. There are three main types of firms that use derivatives. These are investment banks, commercial banks, and end users, such as floor traders, corporations, and hedge and mutual funds. While you can still lose money in derivatives trading, the risk is much less of an investment. Further, you can get involved in derivatives trading for a much lower initial investment, something that may appeal to those who cannot or do not want to invest as much as is required to purchase stock. Derivatives can also be a good way to add balance to your total portfolio, thereby spreading risk throughout a variety of investments rather than in only a few. 2. They can be a Good Short Term Investment If you are looking for an investment opportunity that can pay off in a shorter time frame, derivatives may be a good option. While some stocks and bonds are long-term investments over the course of many years, derivatives can be days, weeks, or a few months. Because of the shorter turnaround time, they can be a good way to break into the market as well as a good way to mix short and long-term investments. If you have a portfolio consisting of longterm investments, such as some stocks, and want an option to put your money to work now, derivatives may be an option. Making derivatives work for you requires careful research and consideration just like any other investment opportunity. However, in a fast-paced world, investors have the option to see results much sooner in options or futures trading that are not available through other means.

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3. Variety and Flexibility The nature of derivatives essentially means that the opportunities for trading this type of investment are limited only by the imagination. The other side of this is that someone interested in entering the derivatives trading market needs to either have a trusted financial representative, or learn as much about the business as possible. Doing both is the best option, as you can then work with a financial representative in a much more involved way and have a better handle on what your money is doing and where. Numerous resources are available on the Internet for learning more about derivatives trading and the many options available. Those interested in derivatives training may want to begin by focusing on a particular area, such as currency trading. Some types of trading options are available around the clock, on a global scale. This is another reason some investors are drawn to derivatives trading. Getting involved in the global economy can be exciting, and it opens international options that may not be available through the traditional stock market (particularly given the regulations placed on foreign companies to comply with U.S. laws such as SarbanesOxley). In short, derivatives trading can be an excellent way to either break into the trading market or to round out an existing portfolio. It offers a wide range of options, including international opportunities. Finally, with some skill, research, and a bit of luck, it can be a good way to make your money work for you.

Usage of derivatives
Derivatives are used by investors for the following: provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative; speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level); hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;
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Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives).

Create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

Risks in DERIVATIVES
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as the following: o American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on Credit Default Swaps (CDS).[27] The US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the gifting of money, which came to be known as the "Back door bailout" of Americas largest trading firms, was necessary because over the next few quarters the company was likely to lose more money. o The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts. o The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. o The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank. o UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September, 2011.

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 Counter party risk

Some derivatives (especially swaps) expose investors to counter party risk. Different types of derivatives have different levels of counter party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Large notional value

Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.

Leverage of an economy's debt

Derivatives massively leverage the debt in an economy, making it ever more difficult for the underlying real economy to service its debt obligations, thereby curtailing real economic activity, which can cause a recession or even depression. In the view of Marriner S. Eccles, US Federal Reserve Chairman from November, 1934 to February, 1948, too high a level of debt was one of the primary causes of the Great Depression.

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