CHAPTER 1

Derivatives and Risk Management

By Rajiv Srivastava
(c) Oxford University Press, 2014. All rights reserved.
  Risk can be defined as deviations of the actual results
from expected.
 Risk can be classified in two ways
1) risk of small losses with frequent occurrences and
2) risk of large losses with infrequent occurrences.
 The impact or magnitude of risk is normally estimated
from following two factors
 The probability of an adverse event happening, and
 In case the event occurs the magnitude of the loss it can
cause.

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  The ways to manage risk include attempt to control
potential damage, diffuse it, diversify and/or transfer risk
to those willing to accept it.
 One can manage risk by transferring it to another party
who is willing to assume risk. Risk per se cannot be
eliminated but can be transferred from those trying to
evade to those willing to assume.
 Management of risk through derivatives is commonly
referred as hedging which enable offsetting of risk
emanating from a situation from another.
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  Business risks are characterised by small losses but with
high probability
 The risk of large losses with small probability is referred as
event risk.
 Event risk is normally managed by insurance.

 Business risk is concerned about

 Changes in prices,
 Changes exchange rates, and

 Changes in interest rates.

(c) Oxford University Press, 2014. All rights reserved.

  Business risks are characterised by small losses but with
high probability
 The risk of large losses with small probability is referred as
event risk.
 Event risk is normally managed through insurance.

 Business risk is concerned about frequent and small

 Changes in prices,
 Changes exchange rates, and

 Changes in interest rates.

(c) Oxford University Press, 2014. All rights reserved.

  Risks of price, exchange rate and interest rate can be
managed through products that are specially
designed for hedging.
 These products are classified as derivatives.
 Derivatives are
 the 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.

(c) Oxford University Press, 2014. All rights reserved.

  Variety of derivatives are available; both standard
products that are traded on an exchange as well as
tailor-made, to suit various applications.
 Four broad types of derivative instruments are:
 Forwards,
 Futures,
 Options, and
 Swaps.

 Besides basic products other complex products such as

swaptions, options on futures etc. are also available.

(c) Oxford University Press, 2014. All rights reserved.

  Diversification eliminates unsystematic risk.
 Derivatives can eliminate systematic risk.
 Managing risk of a diversified portfolio through
derivatives renders portfolio risk free, because both risks
– systematic and unsystematic – are eliminated and
hence portfolio is risk free earning only risk free return.
 Diversification and derivatives used simultaneously can
at best be a temporary strategy when the market risk of
the portfolio exceeds risk appetite of the investors.

(c) Oxford University Press, 2014. All rights reserved.

  Insurance eliminates event risk i.e. risk of high losses with
low probability.
 Derivatives can eliminate business risk i.e. the risk of
small losses with high probability.
 Managing risk with insurance requires a) payment of
premium, b) proof of event having taken place, and c)
compensation not exceeding the loss.
 Risk management with derivatives does not have any
such requirements as market pays; the happening of
loss is immaterial.
(c) Oxford University Press, 2014. All rights reserved.
  Strategic risk management is expensive, irreversible,
time consuming and long term.
 Risk management with derivatives is
 Quick
 Reversible
 Inexpensive
 Short term

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 Based on the underlying asset Based on how traded
The underlying asset can be Derivatives can be traded either on
 Commodities
the exchange or OTC
 Over-the-counter (OTC)
 Currencies
 Exchange Traded
 Shares/Indices

 Interest Rates

 Credit

 Weather

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 Hedgers
those who use derivatives for hedging i.e. reduce or eliminate
risk.
Speculators
those who take positions in derivatives to increase returns by
assuming increased risk. They provide much needed liquidity
to markets.
Arbitrageurs
those who exploit mispricing in different markets; They assume
riskless and profitable positions.
All 3 participants are essential for efficient functioning.
(c) Oxford University Press, 2014. All rights reserved.
  Three functions of derivatives

Derivatives
 Enable price discovery

 Facilitate transfer of Risk

 Provide Leverage

(c) Oxford University Press, 2014. All rights reserved.

 Increased volatility:
 Though used for efficient price discovery, derivatives when used
as a speculative product can cause increased volatility in spot
prices.
Increased bankruptcies:
 Derivatives being leveraged products enable taking
disproportionate positions and have led to several disasters and
bankruptcies.
Increased burden of regulations:
 Derivatives transactions hide more than what they reveal, as they
escape accounting. For financial discipline and better disclosures
new rules have to be devised by regulators.

(c) Oxford University Press, 2014. All rights reserved.