Unit 1

Risk Management
Risk Management- Introduction and Concept

Risk Management refers to the practice of identifying potential risks

in advance, analyzing them and taking precautionary steps to reduce
or curb the risk
 Objectives of Risk Management
(Source- ICAI)
1. Develop a common understanding of risk across multiple functions and
business units so as to manage risk-effectively on an enterprise wide
basis.
2. Achieve a better understanding of risk for competitive advantage.
3. Build safeguards against earnings-related surprises.
4. Build and improve capabilities to respond effectively to low probability,
critical, catastrophic risks.
5. Achieve cost savings through better management of internal resources.
6. Allocate capital more efficiently.
Role of insurance in risk management
Insurance policies are contracts in which the underwriters agree
to assume certain risks for a premium, the consideration
required in all legal contracts. Insurance is a tool in the risk
management process but doesn't cover all the risks to which
your company/organization may be exposed.
 Derivative
A derivative is a financial contract that derives its value from
an underlying asset.

A change in the underlying asset leads to an equivalent change in

the derivative.
Derivative Derivative

Cheese Curd

Milk

Underlying Asset
Derivative Derivative

Underlying Asset
Types of Derivatives
Classification of derivatives
• Over the Counter (OTC)
The derivatives are traded privately without an exchange.
Forward and SWAP

• Exchange-traded derivative contracts (ETD)

Traded in a derivatives exchange.
Future and Options
Role of Derivative Instruments/
Functions of Derivative Market
1. Risk management

2. Price discovery

3. Operational advantages
Participants of Derivatives Market
1. Hedgers
Hedging is when a person invests in financial markets to reduce the risk of
price volatility/fluctuations i.e., eliminate the risk of future price movements.
Derivatives are the most popular instruments in the sphere of hedging. It is
because derivatives are effective in offsetting risk with their respective
underlying assets.

2. Speculators
Speculation is the most common market activity that participants of a financial
market take part in. It is a risky activity that investors engage in. It involves the
purchase of any financial instrument or an asset that an investor speculates to
become significantly valuable in the future. Speculation is driven by the motive
of potentially earning lucrative profits in the future.
Participants of Derivatives Market
3. Arbitrageurs
Arbitrage trading involves buying a commodity or security at a low price
in one market and selling it at a high price in the other market.
• Hedging = Reducing Risk
• Speculation =Taking Risk