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CHAPTER 1

DERIVATIVES – AN INTRODUCTION
Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press

and 2.Risk 2    Risk can be defined as deviations of the actual results from expected. Copyright © Oxford University Press Derivatives and Risk Management By Rajiv Srivastava Chapter 1 Derivatives – An Introduction . The probability of an adverse event happening. Risk can be classified two ways – 1) risk of small losses with frequent occurrence and 2) risk of large losses with infrequent occurrence. In case the event occurs the magnitude of the loss it can cause. The impact or magnitude of risk is normally estimated from following two factors 1.

Insurance company does not do anything to contain the risk per se but assumes risk on your behalf.Managing Risk 3    The ways to manage risk include attempt to control potential damage. Copyright © Oxford University Press Derivatives and Risk Management By Rajiv Srivastava Chapter 1 Derivatives – An Introduction . diffuse. diversify and transfer risk to those willing to accept it. Management of risk through derivatives is commonly referred as hedging which enable offsetting of risk emanating from one situation. One can manage the risk by transferring it to another party who is willing to assume risk.

 Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction . companies and Business risk is concerned about Changes in prices.Types of Risks 4     Business risks are characterised by small losses but with high probability The risk of large losses with small probability is normally referred as event risk.  Changes exchange rates. and  Changes in interest rates. Event risk is normally managed by insurance.

exchange rate and interest rate can be managed through products that are classified as derivatives.Derivatives 5   Three kinds of business risk of price. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction . Derivatives are products that derive their value from some other asset called underlying asset but in other aspects they may remain distinctly different from and independent of the underlying asset.

Four broad types of instruments are:  Forwards  Futures  Options.Derivative Products 6   Variety of derivatives are available both standard product as well as tailor-made. to suit various applications.  Swaps. and Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction .

Classification of Derivatives 7 Based on the underlying asset Based on how traded The underlying asset can be  Commodities  Currencies  Shares/Indices  Interest Rates  Credit  Weather Derivatives and Risk Management By Rajiv Srivastava Derivatives can be traded either on the exchange or OTC  Over-the-counter (OTC)  Exchange Traded Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction .

Participants in Derivative Markets 8 Hedgers: are those who use derivatives for hedging i. Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction . All 3 participants are essential for efficient functioning. Speculators: are those take positions in derivatives to increase returns by assuming increased risk.e. Arbitrageurs: are those who exploit mispricing in different markets. reduce or eliminate risk. They provide much needed liquidity to markets. They assume riskless and profitable positions.

Functions of Derivatives 9 3 major functions of derivatives are:  Enable price discovery  Facilitate Transfer of Risk  Provide Leverage Derivatives and Risk Management By Rajiv Srivastava Copyright © Oxford University Press Chapter 1 Derivatives – An Introduction .

derivatives when used as a speculative product can make increase volatility in prices. For financial discipline and better disclosures new rules have to be devised.Misuses & Criticism of Derivatives 10    Increased volatility: Though used for efficient price discovery. Increased burden of regulations: Most derivatives hide more than they reveal. Increased bankruptcies: Derivatives being leveraged products have caused disproportionate positions leading to several disasters and bankruptcies. Copyright © Oxford University Press Derivatives and Risk Management By Rajiv Srivastava Chapter 1 Derivatives – An Introduction .