Financial Derivatives &

Risk Management
Objectives:
 Understand the risk, its elements and
uncertainty
 To understand nature of risk
 To study different interpretation of risks
 To know about Risk management process &
methods
 To understand the overall objectives of risk
management is to minimize the cost of risk.
 Is
Risk is symbol of Danger

Or

Symbol of Opportunity ?
 It is
symbol of both
Danger & Opportunity
 The only one thing is certain about
Stock Market is…………..
………….. Uncertainty !
“Playing with F & O is injurious to Wealth”

“ You will burn your money in Derivatives, if not done

in a systematic way”

But at the same time ‘It is Money Vending Machine’.

Learn to make money through……

Trade in Derivatives Systematically & Strategically
 Risk Management
Meaning:
“Risk can be defined as the possibility of loss
arising because of uncertainty of outcome of
particular transaction”.
“Risk refers to variability of the actual returns
from the expected returns in terms of cash
flows”.
“Risk management seeks to mitigate variability
and expected losses and increase welfare”.
Elements of Certainty and Risk

Certainty: Is the situation where it is

known what will happen and the
happening of an event carries a 100
percent probability.
Risk: Is the situation when there are a
number of specific, probable outcomes,
but it is not certain as to which one of
them will actually happen.
 Elements of Uncertainty and Risk….

Uncertainty: Is where even the

probable outcomes are unknown. It
reflects a total lack of knowledge of
what may happen.
The Webster's Dictionary says that ‘ Risk’
is the possibility of something
unpleasant happening or the chance of
encountering loss or harm.
Nature of risk:
 Important nature of risk is uncertainty. One
cannot predict risk when it will occur. Its
period of occurrence is not known.
 It relates to theory of probability and it
standards more on guess work rather than
actual.
 Risk exists in any activities when the decision
maker is in a position to assign probabilities
to various outcomes.
 Different Interpretation of Risk

Risk can be divided into;

1. Pure Risk (PR) and Speculative Risk
(SR):
PR are those in which the outcome tends to be a
loss with no possibility of gain.
Ex: the risk of fire in a godown
SR are those in which there is a possibility of gain
or loss.
Ex: Secondary market
While PR can be insured
SR cannot be insured
Pure risk encompasses risk of loss from (a) damage
to and theft or expropriation of business assets,
(b) legal liability for injuries to customers and
other parties, (c) workplace injuries to
employees, and (d) obligations assumed by
businesses under employee benefit plans.
Pure risk frequently is managed in part by the
purchase of insurance to finance losses and
reduce risk.
2. Acceptable and Non-acceptable Risk:
While risks are unavoidable in any business the
potential loss may be so minimal. Ex: a loss
of few stationeries in a month is acceptable.
Certain risks are major and those are known as
non-acceptable. Ex. A major financial loss of
Rs.50 crore is non-acceptable risk.
3. Static Risks and Dynamic Risks:
Risks that do not depend on various
scenarios like pure risks are a type of
static risks
Some risks depend on changes in the
economical, political, social and other
scenarios like speculative risks are a
type of dynamic risks.
Risk Management

Risk management is a systematic approach in

identifying, analyzing and controlling areas or
events with the potentials for causing unwanted
change. It is through risk management that risks to
any specific programmed are assessed and
systematically managed to reduce risk to an
acceptable level.
Types of Risk (Business & Individuals)

1. Business Risk : Is concerned with

possible reductions in business value
from any source. The business value
include Price risk, Credit risk and Pure
risk.
2. Personal Risk: The risks faced by
individuals and families viz., earnings
risk, medical expense risk, liability risk,
physical asset risk, financial asset risk.
Risk Management Process
Risk Mgmt. process involves:
1. Identify all significant risks.
2. Evaluate all potential frequency and
severity of losses.
3. Develop and select methods for managing
risk.
4. Implement the risk management methods
chosen.
5. Monitor the performance and suitability of
the risk management methods and
strategies on an ongoing basis.
Risk Management Methods:
Major risk management methods include:
1. Loss control
2. Loss financing
3. Internal risk reduction
Loss control & Internal risk reduction are
commonly involve decisions to invest
resources to reduce expected losses.
Loss financing decisions refer to decisions about
how to pay for losses if they do occur.
 RM methods contd…..

Loss Control Loss Financing Internal risk reduction

Reduced level of Retention and Diversification

risky activity self-insurance

Increased
Insurance
precautions

Hedging

Other contractual
risk transfers
Objectives
The overall objectives of risk management is to
minimize the cost of risk.
Risk mgmt. seeks to mitigate variability and
expected losses and increase welfare.

Cost of risk:
Components of the cost of risk include;
1. the expected cost of loss,
2. the cost of loss control,
3. the cost of loss financing,
 Cost of risk contd…..

4. the cost internal risk reduction, and

5. the cost of any residual uncertainty that
remains after loss control, loss financing, and
internal risk reduction methods have been
implemented.
In the context of business risk management,
maximizing firm value is equivalent to
minimizing the cost of risk.
 - End -