UNIT VI

FINANCIAL RISK
MANAGEMENT
 FINANCIAL RISK MANAGEMENT
TECHNIQUES

Financial risk management is a process that includes

companies setting up guidelines to define their policy
on accepting financial risk.

MAJOR TECHNIQUES:
• Derivatives
• Hedging
• Portfolio Management
 DERIVATIVES

A derivative is an
instrument that derives its
value from the value of an
underlying assest,typically a
commodity, bond, equity or
currency.

When the price of the

underlying changes, the value
of the derivative also changes.
 FORWARDS
• A forward is a contract in which one party commits
to buy and the other party commits to sell a
specified quantity of an agreed upon asset for a pre-
determined price at a specific date in the future.

• It is a customized contract, in the sense that the

terms of the contract are agreed upon by the
individual parties.

• Hence, it is traded OTC.

 Forward Contract Example
I agree to sell Bread
Farmer 500kgs wheat at
Maker
Rs.40/kg after 3
months.

3 months
Later
500kgs wheat Bread
Farmer Maker
Rs.20,000
RISKS IN FORWARD CONTRACTS

• Credit Risk – Does the other party have the means to

pay?

• Operational Risk – Will the other party make delivery?

Will the other party accept delivery?

• Liquidity Risk – Incase either party wants to opt out of

the contract, how to find another counter party?
 FUTURES
• A future is a standardized forward contract.
• It is traded on an organized exchange.
• Standardizations-
- quantity of underlying
- quality of underlying(not required in financial
futures)
- delivery dates and procedure
- price quotes
 TERMINOLOGY
• Contract size – The amount of the asset that has to be
delivered under one contract. All futures are sold in
multiples of lots which is decided by the exchange
board.
Eg. If the lot size of Tata steel is 500 shares, then one
futures contract is necessarily 500 shares.

• Contract cycle – The period for which a contract

trades.
The futures on the NSE have one (near) month, two
(next) months, three (far) months expiry cycles.
 TERMINOLOGY

• Expiry date – usually last Thursday of every month

or previous day if Thursday is public holiday.

• Strike price – The agreed price of the deal is called

the strike price.

• Cost of carry – Difference between strike price and

current price.
 DISTINCTION BETWEEN FUTURES
AND FORWARDS
S. Future Contract Forward Contract
No
1 Traded on an organized Over the Counter (OTC) in
stock exchange nature
2 Standardized contract Customized contract terms,
terms, hence, more liquid. hence, less liquid
3 No margin payment
Requires margin payments
4 Settlement happens at the
Follows daily settlement end of the period
 OPTIONS
• Contracts that give the holder the option to buy/sell
specified quantity of the underlying assets at a
particular price on or before a specified time period.

• The word “option” means that the holder has the

right but not the obligation to buy/sell underlying
assets.
 TYPES OF OPTIONS
• Options are of two types – call and put.

• Call option gives the buyer the right but not the
obligation to buy a given quantity of the underlying
asset, at a given price on or before a particular date by
paying a premium.

• Puts gives the buyer the right, but not obligation to sell
a given quantity of the underlying asset at a given price
on or before a particular date by paying a premium.
 OPTIONS TERMINOLOGY
• Underlying: Specific security or asset.
• Option premium: Price paid.
• Strike price: Pre-decided price.
• Expiration date: Date on which option expires.
• Exercise date: Option is exercised.
• Open interest: Total numbers of option contracts
that have not yet been expired.
• Option holder: One who buys option.
• Option writer: One who sells option.
 SWAPS
• In a swap, two counter parties agree to enter into a
contractual agreement wherein they agree to
exchange cash flows at periodic intervals.
• Most swaps are traded “Over The Counter”.

TYPES:
• Interest rate swaps
• Currency swaps
 INTEREST RATE SWAPS
• A company agrees to pay a pre-determined fixed
interest rate on a notional principal for a fixed
number of years.

• In return, it receives interest at a floating rate on the

same notional principal for the same period of time.

• The principal is not exchanged. Hence, it is called a

notional amount.
 INTEREST RATE SWAP EXAMPLE

LIBO LIBOR
R SWAPS
Co.A BANK Co.B
Aim - VARIABLE 8 8.5% Aim - FIXED
%

5m 7 5m LIBOR
+ 1%
% Notional Amount =
£ 5 million

Bank A Bank B
Fixed 7% Fixed 10%
Variable LIBOR Variable LIBOR + 1%
nterest rate swaps usually involve the exchange of one stream of future payments
based on a fixed interest rate for a different set of future payments that are based
on a floating interest rate. Thus, understanding the concepts of fixed-rate loans vs.
floating rate loans is crucial to understanding interest rate swaps.

A fixed interest rate is an interest rate on a debt or other security that remains
unchanged during the entire term of the contract, or until the maturity of the
security.

In contrast, floating interest rates fluctuate over time, with the changes in interest
rate usually based on an underlying benchmark index. Floating interest rate bonds
are frequently used in interest rate swaps, with the bond’s interest rate based on
the London Interbank Offered Rate (LIBOR).

Briefly, the LIBOR rate is an average interest rate that the leading banks
participating in the London interbank market charge each other for short-term
loans.

The LIBOR rate is a commonly used benchmark for determining other interest rates
that lenders charge for various types of financing.
Note that while both parties to an interest rate swap get what they want – one
party gets the risk protection of a fixed rate, while the other gets the exposure to
potential profit from a floating rate – ultimately, one party will reap a financial
reward while the other sustains a financial loss. If interest rates rise during the
term of the swap agreement, then the party receiving the floating rate will profit
and the party receiving the fixed rate will incur a loss. Conversely, if interest rates
decline, then the party getting paid the guaranteed fixed rate return will benefit,
while the party receiving payments based on a floating rate will see the amount of
the interest payments it receives go down.
 CURRENCY SWAPS
• It is a swap that includes exchange of principal and
interest rates in one currency for the same in another
currency. It is considered to be a foreign exchange
transaction.
• It is not required by law to be shown in the balance
sheets. The principal may be exchanged either at the
beginning or at the end of the tenure.
• However, if it is exchanged at the end of the life of
the swap, the principal value may be very different.
• It is generally used to hedge against exchange rate
fluctuations.
 DIRECT CURRENCY SWAP
EXAMPLE
• Firm A is an American company and wants to borrow
€40,000 for 3 years.

• Firm B is a French company and wants to borrow

$60,000 for 3 years.

• Suppose the current exchange rate is €1 = $1.50.

 DIRECT CURRENCY SWAP EXAMPLE

7%
Firm A Firm B
Aim -
Aim - EURO 5% DOLLAR

$60th 7% €40t 5%
h

Bank A Bank B

€ 6% € 5%
$ 7% $ 8%
 ADVANTAGES OF DERIVATIVE
MARKET

• Diversion of speculative instinct from cash market

to derivatives.
• Increased hedge for investors in cash market.
• Reduced risk of holding underlying assets.
• Lower transaction costs.
• Enhance price discovery process.
• Increase liquidity for investors and growth of
savings flowing into these markets.
• Increases volume of transactions.
END