Derivatives and Risk

Managment

Group members:

Abhishek Karekar PG-13-04

Esha Kudtarkar PG-13-05
Nilesh Vishwakarma PG-13-51
Rohan Kholi PG-13-53
Kimaya Kale PG-13-66
Jaitashree Hukerikar PG-13-77
Vrushali Utekar PG-13-82
What Are Derivatives
A derivativeis a special type of contract thatderivesits value from
the performance of an underlying entity. This underlying entity can
be an asset, index, or interest rate, and is often called the
"underlying"

Two Kinds of derivatives:

1) Financial
2) Commodity
OTC Market
Trading financial instruments such as stocks, bonds, commodities or
derivatives directly between two parties without going through an
exchange or other intermediary.

Over-the-counter(OTC) oroff-exchangetrading is done directly

between two parties, without any supervision of anexchange.

Over-the-counter markets are uncontrolled and unregulated.

Exchange-traded Derivatives(ETD)

(ETD) are those derivatives instruments that are traded via specialized
derivatives exchange or other exchanges. A derivatives exchange is a
market where individuals trade standardized contracts that have been
defined by the exchange.

There is a very visible and transparent market price for the derivatives.
Participants in a derivative market

Hedger
An investor who takes steps to reduce the risk of an investment by
making an offsetting investment.

Here the risk is Volatility associated with the assets price.

Their goal is to protect their profit limit their expenses

Participants in a derivative market
Speculator
A trader who enters the futures market for pursuit of profits, accepting risk in
the endeavor. They provide liquidity and depth to the market.

Arbitrageur
A person who simultaneously enters into transactions in two or more
markets
to take advantage of the discrepancies between prices in these markets.

Arbitrage involves making profits from relative mispricing.

Types Of Derivatives
Types of derivatives

Forwards Futures Options Swaps

What is a Forward?

A forward is a contract in which one party commits to buy and the other
party commits to sell a specified quantity of an agreed upon asset for a pre-
determined price at a specific date in the future.

It is a customized contract, in the sense that the terms of the contract are
agreed upon by the individual parties.

Hence, it is traded OTC.

Forward Contract Example
I agree to sell
Farmer 500kgs wheat Bread
at Rs.40/kg Maker
after 3
months.

3 months
Later
500kgs Bread
Farmer wheat
Maker
Rs.20,00
0
What are Futures?
A future is a standardized forward contract.

It is traded on an organized exchange.

Standardizations-
- quantity of underlying
- quality of underlying(not required in financial futures)
- delivery dates and procedure
- price quotes
Pricing of Forwards and Futures
The price that the underlying asset is bought or sold for is called the delivery
price.

This price must be fair i.e it must be chosen so that the value of the contract
to both parties is zero at the onset. This is the principle of no arbitrage .
What are Options?
Contracts that give the holder the option to buy/sell specified quantity of the
underlying assets at a particular price on or before a specified time period.

The word option means that the holder has the right but not the obligation
to buy/sell underlying assets.
Types of Options
Options are of two types call and put.

Call option gives the holder the right but not the obligation to buy a given
quantity of the underlying asset, at a given price on or before a particular
date by paying a premium.

Put option gives the holder the right, but not obligation to sell a given
quantity of the underlying asset at a given price on or before a particular
date by paying a premium.
Call Option Example
CALL OPTION Current Price =
Premium Rs.250
=Rs.25/share
Right to buy 100
Amt to buy Call Reliance shares at a
price of Rs.300 per Strike Price
option = Rs.2500
share after 3 months.
Expiry date

Suppose after 3 months,

Market price is Rs.400, Suppose after 3months,
then the option is market price is Rs.200, then
exercised i.e. the shares the option is not exercised.
are bought. Net Loss = Premium amt
Net gain = 40,000-30,000- = Rs.2500
2500 =
Put Option Example
PUT OPTION Current Price =
Premium = Right to sell Rs.250
Rs.25/share 100 Reliance
Strike Price
Amt to buy Put shares at a
option = Rs.2500 price of Rs.300
per share after Expiry
3 months. date
Suppose after 3 months,
Market price is Rs.200, then Suppose after 3 months,
the option is exercised i.e. market price is Rs.300, then
the shares are sold. the option is not exercised.
Net gain = 30,000-20,000- Net Loss = Premium amt
2500 = Rs.7500 = Rs.2500
What are SWAPS?
In a swap, two counter parties agree to enter into a contractual agreement
wherein they agree to exchange cash flows at periodic intervals.

Swaps are customized contracts that are traded in the over-the-counter

(OTC) market between private parties.

2 main types of swaps

Plain vanilla fixed for floating swaps Fixed for fixed currency swaps
or or
simply interest rate swaps. simply currency swaps.
 Interest Rate Swap

A company agrees to pay a pre-determined fixed interest rate on a notional

principal on a specific date for a specified period of time.

In return, it receives interest at a floating rate on the same notional principal

for the same period of time.

The principal is not exchanged. Hence, it is called a notional amount.

Example
On Dec. 31, 2006, Company A and Company B enter into a five-year swap
with the following terms:
(i) Company A pays Company B an amount equal to 6% per annum on a
notional principal of $20 million.
(ii) Company B pays Company A an amount equal to one-year LIBOR + 1%
per annum on a notional principal of $20 million.

At the end of 2007, Company A will pay Company B

$20,000,000 * 6% = $1,200,000.

On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will
pay Company A
$20,000,000 * (5.33% + 1%) = $1,266,000.
 Currency Swap

It is a swap that includes exchange of principal and interest rates in one

currency for principal and fixed interest payments on a similar loan in
another currency

The principal may be exchanged either at the beginning or at the end of the
tenure.
Example
Company X, a U.S. firm, and Company Y, a European firm, enter into a five-
year currency swap for $50 million. Let's assume the exchange rate at the
time is $1.25 per euro.

First, the firms will exchange principals. So, Company X pays $50 million,
and Company Y pays 40 million euros.

Then, at intervals specified in the swap agreement, the parties will exchange
interest payments on their respective principal amounts.
Example
Let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the
euro-denominated interest rate is 3.5%.

Thus, each year, Company X will pay company Y

40,000,000 euros * 3.5% = 1,400,000 euros

Company Y will pay Company X

$50,000,000 * 8.25% = $4,125,000

Finally, at the end of the swap (usually also the date of the final interest
payment), the parties re-exchange the original principal amounts. These
principal payments are unaffected by exchange rates at the time.
Advantages of
Derivatives
Provides Leveraging:
In derivatives market people can transact huge transactions with small
amounts and therefore it gives the benefit of leverage and hence even
people who have less amount of money can enter into this market.

Lower Transaction costs:

It translates into low transaction costs due to the high no. of participants
that take part in the market.

Facilitates Transfer of Risk:

Derivatives instruments redistribute risk between the various market
participants. It provides means to hedge against unfavorable market
movements in return for a premium, and provides opportunities to those
who are willing to take risks and make profits in the process.
Disadvantages of
Derivatives
Raises Volatility:
As a large no. of market participants can take part in derivatives with a
small initial capital due to the leveraging which derivatives provide, it leads to
speculation and raises volatility in the markets.

Higher no. of Bankruptcies:

Due to leveraged nature of derivatives, participants assume positions which
do not match their financial capabilities and eventually lead to bankruptcies.

Complex in nature
It is quite complex and various strategies of derivatives can be implemented
only by an expert and therefore for a layman it is difficult to use this and
therefore it limits its usefulness.
Derivative Strategies
&
Combination of options
Long Call
The investors who are very bullish about the prospects
for a stock / index, buying calls can be an excellent way
to capture the upside potential with limited downside risk.

When to Use: Investor is very bullish on the stock /

index.

Risk: Limited to the Premium.(Maximum loss if market

expires at or below the option strike price) .

Reward: Unlimited

Breakeven: Strike Price +Premium

Synthetic Long Call
BUY STOCK, BUY PUT

When to use: When ownership is desired of stock yet

investor is concerned about near-term downside risk.
The outlook is conservatively bullish.

Risk: Losses limited to Stock price + Put Premium Put

Strike price

Reward: Profit potential is unlimited.

Break-even Point: Put Strike Price + Put Premium +

Stock Price Put Strike Price
Short Call
The seller of the option feels the underlying price of a
stock / index is set to fall in the future.

When to use: Investor is very aggressive and he is

very bearish about the stock /index.

Risk: Unlimited

Reward: Limited to the amount of premium

Break-even Point: Strike Price + Premium

Long Put
Buying a Put is the opposite of buying a Call. A Put
Option gives the buyer of the Put a right to sell the
stock (to the Put seller) at a pre-specified price and
thereby limit his risk.

When to use: Investor is bearish about the stock

/index.

Risk: Limited to the amount of Premium paid.

(Maximum loss if stock / index expires at or above the
option strike price).

Reward: Unlimited

Break-even Point: Stock Price - Premium

Synthetic Long Put
When to Use: If the investor is of the view that the
markets will go down (bearish) but wants to protect
against any unexpected rise in the price of the stock.

Risk: Limited. Maximum Risk is Call Strike Price

Stock Price + Premium

Reward: Maximum is Stock Price Call Premium

Breakeven: Stock Price Call Premium

Short Put
An investor Sells Put when he is Bullish about the stock
expects the stock price to rise or stay sideways at the
minimum.

When to Use: Investor is very Bullish on the stock /

index. The main idea is to make a short term income.

Risk: Put Strike Price Put Premium.

Reward: Limited to the amount of Premium received.

Breakeven: Put Strike Price - Premium

Long Straddle
A Straddle is a volatility strategy and is used when the stock price / index is
expected to show large movements.

It involves buying a call as well as put on the same stock / index for the same
maturity and strike price, to take advantage of a movement in either
direction, value of the stock / index.
Long Straddle
When to Use: The investor thinks that the underlying stock / index will
experience significant volatility in the near term.

Risk: Limited to the initial premium paid.

Reward: Unlimited

Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Short Straddle
A Short Straddle is the opposite of Long Straddle. It is a strategy to be
adopted when the investor feels the market will not show much movement.

Investor sells a Call and a Put on the same stock / index for the same
maturity and strike price.
Short Straddle
When to Use: The investor thinks that the underlying stock / index will
experience very little volatility in the near term.

Risk: Unlimited

Reward: Limited to the premium received

Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Long Strangle
A Strangle is a slight modification to the Straddle to make it cheaper to
execute.

This strategy involves the simultaneous buying of a slightly out-of-the-money

(OTM) put and a slightly out-of-the-money (OTM) call of the same underlying
stock / index and expiration date.
Long Strangle
When to Use: The investor thinks that the underlying stock / index will
experience very high levels of volatility in the near term.

Risk: Limited to the initial premium paid

Reward: Unlimited

Breakeven:
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Short Strangle
A Short Strangle is a slight modification to the Short Straddle

This strategy involves the simultaneous selling of a slightly out-of-the-money

(OTM) put and a slightly out-of-the-money (OTM) call of the same underlying
stock and expiration date.
Short Strangle
When to Use: This options trading strategy is taken when the options
investor thinks that the underlying stock will experience little volatility in the
near term.
Risk: Unlimited
Reward: Limited to the premium received
Breakeven:
Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Bull Call Spread Strategy
BUY CALL OPTION, SELL CALL OPTION

Constructed by buying an in-the-money (ITM) call option, and selling another

out-of-the-money (OTM) call option

Net effect is to bring down the cost and breakeven on a Buy Call (Long Call)
Strategy.
Bull Call Spread Strategy

When to Use: Investor is moderately bullish.

Risk: Limited to any initial premium paid in establishing the position.

Maximum loss occurs where the underlying falls to the level of the lower
strike or below.

Reward: Limited to the difference between the two strikes minus net
premium cost. Maximum profit occurs where the underlying rises to the level
of the higher strike or above

Break-Even-Point (BEP): Strike Price of Purchased call+ Net Debit Paid

Bear Put Spread Strategy
BUY PUT, SELL PUT

This strategy requires the investor to buy an in-the-money (higher) put option
and sell an out-of-the-money (lower) put option on the same stock with the
same expiration date.

This strategy creates a net debit for the investor. The net effect of the
strategy is to bring down the cost and raise the breakeven on buying a Put
(Long Put).
Bear Put Spread Strategy

When to use: When you are moderately bearish on market direction

Risk: Limited to the net amount paid for the spread. i.e. the premium paid for
long position less premium received for short position.

Reward: Limited to the difference between the two strike prices minus the net
premium paid for the position.

Break Even Point: Strike Price of Long Put Net Premium Paid
Risk Management
 Meaning & Definition of Risk
Management

A risk can be defined as a situation involving exposure to danger.

Risk management refers to the practice of identifying potential risks in

advance, analyzing them and taking precautionary steps to reduce/curb
the risk.

In order to minimize and control the exposure of investment to such

risks, fund managers and investors practice risk management.
TYPES OF RISKS
WITH REGARDS
TO
DERIVATIVES
Price Risk

Price risk is the risk to earnings arising from changes in the value of
portfolios of financial instruments.

The degree of price risk depends on the price sensitivity of the derivative
instrument and the time it takes to liquidate or offset (close out) the position.

Price sensitivity is generally greater for instruments with leverage, longer

maturities or option features.
Price Risk Management

Reliable and independent pricing and revaluation systems.

Meaningful processes for establishing price risk limits.

Accurate and validated risk measurement processes.

Stress testing.
Interest Rate Risk
Interest rate risk refers to a risk which a financial instrument based on an
underlying financial security carries whose value is affected by changes in
interest rates.

Interest-rate derivatives are hedges used by institutional investors such as

banks to combat the changes in market interest rates.

In general, values of long-term instruments are more sensitive to interest

rate changes than the values of short-term instruments.

Contributing to effective supervision of interest rate risk are:

Appropriate measures to track the market interest rate fluctuations.

Well-formulated policies and procedures.
Reliable pricing and valuation systems.
Foreign Exchange Rates Risk
The exposure from an adverse change in foreign exchange rates is forex
rates risk.

It is a function of spot foreign exchange rates and domestic and foreign

interest rates.

It can be best supervised through:

Regular check on forex rates
Mechanisms to track fluctuations in forex rates

The Foreign Exchange section of the Comptrollers Handbook may be

useful to banks in managing this risk.
Liquidity risk
Liquidity risk is the risk to earnings from a banks inability to meet its
obligations when they come due, without incurring unacceptable losses.

Inability to manage unplanned decreases or changes in funding sources.

Failure to recognize changes in market conditions.

Consideration of market depth and the cash flow characteristics of

particular instruments
Construction of portfolio stress tests.

The management of price, interest rate, and liquidity risk is not conducted in
isolation. As such, the examination of risk management systems for these
three risks should be conducted concurrently.
Credit Risk

It is the risk to earnings of an obligor's failure to meet the terms of any

contract with the bank or otherwise to perform as agreed.

Credit risk arises from all activities in which success depends on

counterparty, issuer, or borrower performance.

Counterparty credit risk can be effectively managed through:

Accurate measurement of exposures,
Ongoing monitoring,
Timely counterparty credit evaluations.
Sound operating procedures.
Risk Management Process
1. Risk Identification and Quantification
2. Decision to Manage or Accept Risk Exposure
3. Risk Management Alternatives
4. Strategy Development and Implementation
5. Monitoring and Reviewing
1.Risk Identification and
Quantification

Interest rate.
Price (valuation).
Credit.
Exchange rate.

Quantification :
Term of risk exposure.
Direction of risk exposure.
2.Decision to Manage or Accept Risk
Exposure
The driving force of any effort to manage risk is the conscious
decision, to either accept or modify the risk exposure quantified

This type of decision needs to be made within the context

established by the goals and objectives based on which further
risk management strategies can be implemented.
3.Risk Management Alternatives
Evaluation of the effectiveness (risks, costs, and benefits) of the various risk
management alternatives.
Focusing on evaluating the risk/reward profile
4.Strategy Development and
Implementation
Clearity in the objectives underlying the strategy.

Ensuring suitability of strategy, both initially and by tactical adjustments on

an on-going basis.

Objectively evaluate (in both favorable and unfavorable market

environments) and select the most suitable strategy for implementation.

Implement the selected strategies and tactical adjustments in a manner

consistent with established and approved policies and procedures.
5. Monitoring and Reviewing
The primary focus of this element of the risk management process is to
ensure accurate accounting, recordkeeping, and reporting of the results of all
strategies. By doing so, objective evaluations of risk management efforts will
be enabled.