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The Derivatives

Various Risks Associated with Derivative


Products

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Various types of risks associated with derivatives product

Derivatives
• Derivatives are the financial instruments whose
value is derived from the underlying assets.
• It is called derivatives as its value is derived from
other assets called underlying asset.
• It is a contract that derives its value from changes in
the price of the underlying asset.
Example 1:
The value of a gold futures contract is derived from
the value of the underlying asset i.e. Gold.
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Various types of risks associated with derivatives product

Examples of Derivatives
• Example 2:
• John (buyer) and Roman (seller) enters into a call
option contract to trade 100 shares of HBL @ Rs.
1400 each; option premium of Rs. 20 per share.
• Example 3:
• Anju and Manju enters into interest rate swap.
Anju and Manju have invested Rs. 10000 in
projects. Anju receives 10 percent interest per
annum, while Manju receives 8 percent LIBOR plus
variable interest rates.

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Various types of risks associated with derivatives product

Examples of Derivatives
• Example 4:
• Anand (Seller) and Manoj (Buyer) enters into
forward contract to transact 10 Ropani of Land @
Rs. 15 lakhs per Ropani after 3 months.

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Various types of risks associated with derivatives product

How there is risk in derivatives?


• The value of derivatives is derived from the
underlying securities; likewise, the risk in
derivatives are also derived from those
underlying assets.

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Various types of risks associated with derivatives product

Risk associated with derivative products


1. Counterparty Risk
2. Market Risk
a) Interest Rate Risk
b) Price Risk
c) Foreign Exchange Risk
3. Liquidity Risk
4. Operational Risk

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Various types of risks associated with derivatives product

Risk associated with derivative products


5. Model Risk
6. Legal Risk
7. Settlement Risk
8. Leverage Effect

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Various types of risks associated with derivatives product

1. Counterparty Risk
• Risk exposed due to default or delinquency by
one of the counterparties,
• If one of the parties of the contract defaults, then
the counterparty default or credit risk arises.
• Example 5:
• John (buyer) and Roman (seller) enters into a
call option contract… (See Slide 3)
• If Roman defaults (assuming that market price
hikes), then John suffers counterparty risk.

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Various types of risks associated with derivatives product

2. Market Risk
• Market risk refers to the possibility of losses due
to fluctuations in interest rates, price and
exchange rates.
• Interest rate swap suffers interest rate risk,
currency swap suffers exchange rate risk, and
option, forward, and futures suffer price risk.
• Example 6:
• Anju and Manju enters into interest rate
swap… (See Slide 3). Anju suffers if interest
rate falls.
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Various types of risks associated with derivatives product

2. Market Risk
• Example 7:
• John (buyer) and Roman (seller) enters into a
call option … (See Slide 3)
• Roman suffers if price rises ( ↑) surpassing
exercise price, while John losses premium if
market price (↓)is less than exercise price.

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Various types of risks associated with derivatives product

3. Liquidity Risk
• Liquidity risk is the risk exposed to derivative
instrument holder either due to illiquid
underlying asset.
• Example 8:
• Anand (Seller) and Manoj (Buyer) enters into
forward contract… (See Slide 3)
• NRB directive not to grant loan for land
purchases after 3 months will make land illiquid.

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Various types of risks associated with derivatives product

4. Operational Risk
• Operational risk is the prospect of loss resulting
from inadequate or failed procedures, systems or
policies. Employee errors. Systems failures.
Fraud or other criminal activity. Any event that
disrupts business processes.
• Operational risk arises through: Industry events,
regulatory development, new technology, and
role of counterparty.

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Various types of risks associated with derivatives product

5. Model Risk
• Model Risk arises because of improper pricing
of derivative securities, which is the resultant of
application of inappropriate model or incorrect
input.
• Example 9:
• Improper pricing of options is its example.
• Valuation of American Option using Black
Scholes Model.

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Various types of risks associated with derivatives product

6. Legal Risk
• Legal risk arises due to failure in enforcing
contract.
• Anand (Seller) and Manoj (Buyer) enters into
forward contract… (See Slide 3). However,
Manoj is unable to purchase the land because of
massive property loss due to earthquake.
Forward contract turns to option… (legal
failure)

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Various types of risks associated with derivatives product

7. Settlement Risk
• Settlement risk is the risk that one party will fail
to deliver the terms of a contract with another
party at the time of settlement.
• It generally incurs in international trade.
• This occurs accidently, while both parties act in
good faith.
• This type of risk can lead to principal risk.

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Various types of risks associated with derivatives product

8. Leverage Effect
• A small change in price of underlying asset will
cause huge profit or loss.
• It is basically seen in option.

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Various types of risks associated with derivatives product

Type of risk and mitigating measures


Types of Risk Mitigating Measures
Counterparty risk Credit derivatives, credit default swaps
Liquidity Risk Portfolio creation
Operational Risk System maintenance
Market Risk Value at risk, Delta hedging
Legal Risk Regulatory legal framework

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Various types of risks associated with derivatives product

ANY QUERIES
???

THANK YOU
!!!

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