Derivatives and risk management - rajiv shrivastava

- R. Madhumati and V. ranganatham

INTRODUCTION TO DERIVATIVES
Derivatives market
- A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial assets (like a security) or set of assets (like an index)
- Instruments that derive their value on their value on the basis of prices of some other
assets are called the underlying assets.
- Spot market drives the derivative market
- Best suited to manage the risk of small losses with high probability.

Importance of derivatives
-Hedging against risk
Commodity derivatives

TYPES OF BUSINESS RISK

1. Price risk
risk that the value of a security or investment will decrease.

2. Exchange rate risk

unavoidable risk of foreign investment, but it can be mitigated considerably through hedging
techniques. The exchange rate risk is caused by fluctuations in the investor’s local currency
compared to the foreign-investment currency.

3. Interest rate risk

the potential for investment losses that result from a change in interest rates.

FACTORS DRIVING THE GROWTH OF DERIVATIVES

1. Increased volatility
Prices are generally determined by market forces. In a market, consumers have
“demand” and producers or suppliers have “supply”, and the collective interaction of
demand and supply in the market determines the price.
These factors are constantly interacting in the market causing changes in the price over
a short period of time. Such changes in the price are known as “price volatility”.

This price volatility risk pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedges to protect against adverse
price changes in commodity, foreign exchange, equity shares and bonds.

2. Global integration
globalization has increased the size of markets and greatly enhanced competition.It is
evident that globalization of industrial and financial activities necessitates use of
 derivatives to guard against future losses. This fact alone has contributed to the growth
of derivatives to a significant extent.

3. Technological advances
A significant growth of derivative instruments has been driven by technological
breakthroughs. These facilitated the more rapid movement of information and
consequently its instantaneous impact on market price.

technological developments increase volatility, derivatives and risk management

products become that much more important.

4. Advances in financial theories

Advances in financial theories gave birth to derivatives. The work of economic theorists
gave rise to new products for risk management which led to the growth of derivatives in
financial markets.

5. Increased awareness about derivatives

Education and awareness programs to the general public through seminars and digital
media.

TYPES OF DERIVATIVES
A. CLASSIFICATION BASED ON PRODUCTS

1. FORWARDS
Forwards are contracts where the buyer and the seller agree to exchange the
asset and its price, at a future date, but at a price fixed in advance. The
underlying asset could be a stock, a foreign currency, a commodity, an interest
rate, or any other. The buyer of the forward contract is called the 'long' and the
seller of the forward contract is called the 'short'.

Both the parties mutually decide the forward contract's terms and
conditions, such as when and where the delivery will take place, and the
quantity and quality of the underlying asset. Due to these features, forward
contacts are known as customized private contracts. In forward contracts,
each party is subject to default risk, that is, the party with a loss on the contract
can possibly default as there is no guarantee against loss.

2. FUTURES
A futures contract is an extension of the forward contract. It has the same
concept and pricing mechanism, but some additional characteristics clearly
differentiate it from a forward contract. Unlike forward contracts, futures are
traded on an exchange. A futures contract can also be defined as an
exchange-traded forward contract. The features of futures contracts are
 standardized in terms of quantity, delivery dates, delivery places, quality of
the product, etc., which facilitate exchange-based trading, unlike forward
contracts.
● Obligation to execute the contract

3. OPTIONS
Options are contracts for delivery in future, like forwards and futures, except that
one of the two parties involved holds the option to withdraw from the
contract, while the other party is obligated to perform at the behest of the
first party. An option is a right without an obligation to buy or sell an asset at a
predetermined price within a specified time interval. The option that gives the
right to buy is known as a call option; an option that gives the right to sell is
known as a put option.

4. SWAPS
Swaps are agreements between two parties to exchange a set of future cash
flows according to a predetermined method. For example, one party may pay
a fixed rate of interest in exchange for receiving a variable rate of interest on a
notional principal amount for specified intervals of time.
● Non exchange traded.

More complex derivatives involve combinations of these products such as

forward swap, swap options, options on futures, etc.

CLASSIFICATION BASED ON UNDERLYING ASSETS

1. COMMODITIES
The commodities on which derivative contracts exist are the following:

• Agricultural products such as rice, wheat, cotton, oils, soya, tea, coffee, rubber, and
pulses, etc.
• Metals such as copper, tin, gold, silver, and aluminium, etc.
● Energy derivatives such as crude oil, natural gas, and heating oil, etc.

2. CURRENCIES
Derivatives can be based on the exchange rates of various currencies, such as US
dollar, Canadian dollar, euro, yen, and Mexican peso. All the basic derivatives of
forwards, fntures, options, and swaps based on exchange rates are actively traded.
Currency derivatives are extensively used by banks and corporations to mitigate foreign
exchange risk. The US dollar dominates currency derivatives trade for historical reasons.

3. INTEREST RATES
Derivatives can also have interest rates as the underlying asset. Internationally LIBOR
(London Interbank Offer Rate) is the most common interest rate used in derivative
 contracts, LIBOR is the interest rate at which one London bank lends dollars to another
London bank. Interest rate derivatives can also be based on instruments whose value is
dependent upon yields on treasury bills (T-bills) and treasury bonds. In India, interest
rate derivatives are best represented by MIBOR (Mumbai InterBank Offer Rate) which is
akin to LIBOR.

4. EQUITY SHARES
The most popular underlying assets of derivatives are stocks. In spite of the forward
contracts' popularity in the past, futures and options on stocks are traded more actively
in India these days.

5. INDICES
Derivatives on various indices in the stock markets are possibly the most sought after
products because of their ability to provide protection against market risk. Futures and
options on stock indices exist all over the world in all major stock exchanges.

6. CREDIT
These contracts are based on the credit rating or credit risk of cash flows such as
instalment on loans and other forms of receivables, Credit default swaps are the most
common derivatives in this category, where the value of the derivative is a function of
default risk. Credit derivatives are actively used by banks and financial institutions
subject to default risk.

7. WEATHER
The objective of weather derivatives is to make natural phenomena as an underlying
asset.

PARTICIPANTS IN DERIVATIVE MARKET

1. HEDGERS
Hedgers are those who enter into a derivative contract with the objective of
covering risk. A farmer growing wheat faces uncertainty about the price of his produce
at the time of the harvest. Similarly, a flour mill that requires wheat also faces uncertainty
of price of input. The farmer and the flour mill can enter into a forward contract, where
the farmer agrees to sell harvested wheat at a predetermined price to the flour mill. The
farmer is apprehensive of a price fall while the flour mill fears price rise. Both the parties
face price risk. A forward contract would eliminate price risk for both the parties. A
forward contract is entered with the objective of hedging against the price risk that is
faced by the farmer as well as the flour mill. Such participants in the derivatives
markets are called hedgers. Hedgers would like to conclude the contract with the
delivery of the underlying asset. In the example, the contract would be settled when
the farmer delivers wheat to the flour mill on the agreed date at a predetermined price.
Both the farmer and the flour mill have avoided price risk.
 2. SPECULATORS
Speculators are those who enter into a derivative contract to make profit by assuming
risk. The derivative price reflects the expected price of the asset in future. Speculators
have an independent view of the future price of the underlying asset and take
appropriate positions in derivatives with the intention of making profit later. Speculators
have a different view on the price of the asset than the one reflected in the price of the
derivative.

If only hedgers were to operate in the derivatives market, the number of participants in
the market would have been extremely limited. If speculators are permitted to operate,
the hedgers need not look for an exact match, and instead they can deal with the
middlemen who would buy the produce from the farmer in advance, anticipating a hike in
wheat price in future at the time of harvest. By entering into a contract on the derivatives,
the speculators are assuming the risk of price in future.

3. ARBITRAGEURS
Arbitrageurs are the third category of participants in the derivatives market. An
arbitrageur performs the function of making the prices in different markets converge and
be in tandem with each other. While hedgers and speculators want to eliminate and
assume risk, respectively, the arbitrageurs take riskless positions and yet earn profit.
Arbitrageurs constantly monitor the prices of different assets in different markets and
identify opportunities to make profits that emanate from mispriced assets in two markets.
The most common example of arbitrage is the price difference that may be prevailing in
different stock markets.

FUNCTIONS OF DERIVATIVES
Risk management:
The prices of derivatives are related to their underlying assets, as mentioned before. They can
thus be used to increase or decrease the risk of owning the asset. For example, you can reduce
your risk by buying a spot item and selling a futures contract or call option. This is how it works.
If there is a fall in the spot price, the corresponding futures and options contract will also fall.

Price discovery:
Derivative market serves as an important source of information about prices. Prices of derivative
instruments such as futures and forwards can be used to determine what the market expects
future spot prices to be. In most cases, the information is accurate and reliable. Thus, the
futures and forwards markets are especially helpful in the price discovery mechanism.

Operational advantages:
Derivative markets have greater liquidity than the spot markets. The transaction costs therefore,
are lower. This means commissions and other costs for traders are lower in derivatives markets.
Further, unlike securities markets that discourage shorting, selling short is much easier in
derivatives.
Therefore, by virtue of risk management, short selling, price discovery, and improved liquidity,
derivatives make the markets more efficient.

TYPES OF HEDGING

1. Passive hedging
Passive hedging is used by highly risk-averse companies, which would like to be completely
certain of the future cash flows through hedging their entire risk exposures; It is achieved by
locking a specific price either through long term contracts between the supplier and buyer and
through a derivative contract such a futures, forwards and swaps that are available on
exchanges and also as over the counter bilateral contracts.

2. Active hedging
Active hedging approach seeks to achieve a balance between risk hedging and the cost of
hedging by hedging, part of the overall exposures either through long-term contracts or a
derivative instrument and keeping the remaining exposure un-hedged so as to benefit from any
potential favorable market movement on the unhedged part. Only a fraction of the firm's risk
exposure is hedged, and this percentage is continuously reviewed by the firm.

3. Strategic hedging
Strategic hedging considers the overall risk exposure of the firm with respect to its cashflow.
Such strategic hedging is not carried out on a single transaction or type of risk. Derivative
exposures are based on the firm's forecast mostly using simulations to reflect the effect of
several risk parameters on the firm's cashflows.

TRADING MECHANISM
• Exchange traded derivative instruments operate through a trade terminal during specified
trade hours.

. When an order is entered by the trader in the trading terminal it undergoes a process of local
validations.

• After this, the order is passed to the order routing system (ORS).

The ORS passes the order to the risk management system where it is validated against the
defined pre-trade risk parameters and limits. If any violation takes place, a warning message is
displayed, indicating the reason and type of violation that takes place.

• There is a facility to make changes and resubmit the same order.

• If the order does not cause any violation, it is sent to the exchange.

The exchange performs validation on the order before sending the confirmation back
• When the order is received by the exchange, it sends an acknowledgement back to the trading
system.

NSE Derivative Segment

• The derivative segment commenced its operation in June 2000.

Types of traders we have in stock market ; CLEARING MEMBERS :-

1. Trading member - cum clearing member (TM-CM) : Can clear and settle their own trades, the
trades of their clients and trades of other trading members.

2. Professional clearing member (PCM) : Exclusively performs a clearing and settlement

function. These are not trading members. Banks usually become the PCMs.

3. Self clearing members (SCM) : Performs clearing and settlement of trades and trades of their
client but does not clear and settle trades for other trading members.

● A TRADING MEMBER can execute their own trades and the trade on behalf of their
clients. The SEBI has made it mandatory for every trading member to collect required
information for each client in “KNOW YOUR CLIENT FORMAT”.
● The Derivative trading member is expected to educate all their clients on the derivative
risks by providing a copy of the RISK DISCLOSURE DOCUMENT.
● A participant is recognized by the stock exchange as a client of a trading member. Most
of the time participants are FINANCIAL INSTITUTIONS, INDIVIDUALS OR FIRMS. may
trade through multiple trading members but settle all their trades through a single
clearing member.
● National Securities and Corporation Limited(NSCCL) :- clearing and settlement
agency for all trades executed on the derivative exchange segment of the NSE in India.
NSCCL clears all transactions on behalf of the stock exchange.

TRADING FUNCTIONS AND MECHANISMS

Derivatives trade order can be broken down into:
1. Derivatives free trading : free trading comprises the origination and channeling of derivative
order to market places for the execution of transaction

2. Derivatives trading and clearing :- It consists of matching buyers to sellers in derivatives

contracts. Execution means that the buyer and seller enter into a derivative contract.

Derivative clearing manages the open contract, it is closely linked to derivative trading because
open contracts can be traded again and need to be managed throughout the maturity duration
of the contract.
POSITION MANAGEMENT : it is an essential element of derivative clearing which deals
with tracking of open derivative contracts.
 TERMINATION OF DERIVATIVE CONTRACT : It is another clearing function which can
be triggered by canceling the original contract, giving up the contract to another party,
expiry of the contract on maturity, exercise of the contract.

3. Payment and delivery:-

Unit 6
APPLICATION OF FUTURES

1. Futures as a derivative instrument

Types & application:
- It is a standardized contract that is traded in organized exchanges.
- It is traded in specified incremental numbers to enhance liquidated in the market
- Trading through organized exchanges enables the sellers and the buyers of a futures
contract to trade with the exchange concerned rather than with a specified counter
Party.

LONG POSITION
It is an obligation to purchase the underlying asset in a specified quantity and grade at a
future price.
SHORT POSITION
Obligation to deliver the underlying asset in a specified quantity and grade at a future price.

TYPES OF FUTURES

1. COMMODITY FUTURES
Have as their underlying asset any commodity like metal, agro products that is traded in
commodity exchange.
It helps in protecting the participants against their commodity market price exposures
2. SECURITY FUTURES
Underlying assets are any security recognized for the derivative futures market.
The security futures safeguard against the risk of changes of security prices.
3. CURRENCY FUTURES
Represents the international exchange rate b/w the currencies of 2 economies.
Currency futures provide hedge against exchange rate fluctuations for firms involved in
importing or exporting products or services.
4. INTEREST RATE FUTURES
Financial institutions find it useful to enter into interest rate futures to protect their
balance sheet exposure. Lending and investment activities of bank at fixed rate would
expose them to interest rate risk that can be hedged against through an interest rate
futures contract.
Interest rate futures have as their underlying asset notional bond instruments such as
govt. bond securities
DISTINCTION B/W FORWARD AND FUTURES (imp)

1. Basis : liquidity
Forwards: poor
Futures: high
2. Basis: Counterparty risk
Forwards: It exist and is assumed by the counterparty
Futures: It exist and is assumed by the clearing party
3. Price discovery
Forwards: Poor price discovery
Futures: reasonable price discovery
4. Basis: Market
Forward: fragmented market
Futures: common platform

APPLICATION OF OPTIONS
Options as derivative instruments (types & application)
OPTIONS LIMIT:
It limits the loss scenario of investors.
It gives the buyer of the contract the right but not the obligation to transact at a prespecified
price.
STRIKE PRICE:
The prespecified price of the contract is the strike price

APPLICATIONS OF FUTURES AND OPTIONS

MARGIN
● Margin is the collateral that the investor has to deposit to the broker or the exchange in
order to cover the credit risk that the investor possess to the broker or exchange.
● An investor can create risk if they borrow cash to buy a financial asset, buy a financial
asset and sell them short or enter into a derivative contract

MARGINING SYSTEM
● The margins are linked with the volatility of the price of the underlying asset. Since
prices of individual stocks are considered more volatile than the index, the margin
requirements for futures on individual stocks is higher.

● With the initial margin covering the potential loss on any given day, the loss for the day
that has just gone by must be made good to the exchange if the position is carried
forward to the next day.

● Profit, if any, on the outstanding position would be paid by the exchange to the investor.
The exchange deems all positions closed at the end of the day.
 ● The amount of profit or loss that would have accrued if the investors were to close out
their positions at the end of the day is called the MTM margin.

● All outstanding positions are brought to a common value called clearing or settlement
price.
COST OF CARRY MODEL
►In case of financial futures, the cost to carry comprises only the interest cost adjusted for
dividend yield on the index.

It represents the cost of funds that would be incurred if a similar position would be taken in the
cash market and carried till maturity of the futures contract, less any income, typically dividends
accruing on the stocks comprising the index.

Futures price = spot price + cost of carry r- benefits of ownership d

Cost of carry = financing cost in case of stock index futures/financial assets.

FEATURES AND SPECIFICATION OF STOCK/INDEX FUTURES

1. Contract size
The minimum contract value is set to be close to rs, 2 lakh at the time of introduction.
The minimum lot for the BSE sensex was fixed at 50, while for nifty it was 200 initially.
Today, the size of the lot in the nifty futures contract is also set at 50.

2. Contract value
Each point is considered to be equivalent to rs.1. If nifty has a value of 5000, then the
contract size would be 5000*50 *rs.1= 250,000

3. Tick size
Tick size indicates the minimum change that is allowed in the price quotation. It is fixed
at 0.05 points for both Sensex and nifty. Hence the minimum change in value of a nifty
contract will be 50*0.05 = r.2.50

4. margin
For futures contracts, an initial margin determined by the stock exchange has to be kept.
Besides the initial margin profit or loss adjustments on a daily basis (MTM) are also
required.
2 types of margin : initial margin & MTM

5. No. of contracts
At any point of time, 3 monthly contracts are available. Therefore, the period of hedge or
speculation is confined to next 3 months.
The contract expiring first is referred to as the near month contract and the contract
expiring last is called far month contract.
 6. Maturity or expiry
Each contract expires on the last thursday of the delivery month. A new series comes
into existence on the following friday.

7. settlement
As indices are non deliverable, a futures contract is cash settled. However, obligations
under futures contract can be liquidated by entering into a contract opposite to the
original contract before expiry. If not closed the last date of trading, the open position is
automatically closed on that day at a price determined by the exchange called the final
settlement price.

27TH OCT
Hedging Through Index Futures

▸ Short hedge: Investors long on their portfolios or their stocks have a risk of decline in the
value of their assets in case the price declines. They need to protect the value of their portfolio
against the fall in price.

► For example, let us consider an MF that fears a fall in the value of the portfolio in the near
future. While owning the portfolio and expecting the market to fall, it has the following options:

Do nothing: with faith in long term investment fundamentals, the MF may decide to
remain invested and do nothing about the temporary fall in value expected.

Sell and Buy back: The fund can sell the portfolio now and buy back later when the
prices have fallen. Drawbacks transaction cost; Impact cost (big fund house triggering
panic selling); risk proves illusory.

Hedge with futures: the fund must sell futures now and buy later keeping the portfolio
intact. Such a strategy will save transaction cost as well as impact cost and besides will
keep the intention confidential.

If the market falls as expected, the value of the portfolio would decline but the position in
futures would result in profit compensating for the loss in the value of the portfolio.

So if the market appreciated instead, the value of the portfolio would increase but this
would be offset by the loss in the futures position.

30th oct
OPTIONS

Call option
A right, but no obligation to buy the underlying asset at a predetermined price within a s