Derivatives & Risk

Management

1
 Risk Management - Intro

What is Risk?
A risk is a potential problem it might happen
and it might not
Conceptual definition of risk
Risk concerns future happenings
Risk involves change in mind, opinion, actions, places,
etc.
Risk involves choice and the uncertainty that choice
entails
Two characteristics of risk
Uncertainty the risk may or may not happen, that is,
there are no 100% risks
2 Loss the risk becomes a reality and unwanted
 Risk Categorization

Project risks
They threaten the project plan
If they become real, it is likely that the project schedule
will slip and that costs will increase
Technical risks
They threaten the quality and timeliness of the software
to be produced
If they become real, implementation may become
difficult or impossible
Business risks
They threaten the viability of the business
If they become real, they jeopardize the project or the
3
product
 Role Risk Manager

Identification of nature and type of risk

Remedial measures for managing
Determining the cost of managing the
risk (CB Analysis)

4
 Risk Management Process
1) Identify possible risks; recognize what can go
wrong
2) Analyze each risk to estimate the probability
that it will occur and the impact (i.e.,
damage) that it will do if it does occur
3) Rank the risks by probability and impact
- Impact may be negligible, marginal, critical,
and catastrophic
4) Develop a contingency plan to manage those
risks having high probability and high impact

5
 Guidelines for Risk Management
Common goal of risk management and
financial management
Proper mix of risk management techniques
Proactive risk management
Flexibility
Bringing risk to the optimal level
Risk substitution

6
 Risk Management Tools
Hedging
Forwards
Futures
Options
Swaps
Hybrid Debt Securities

7
 Basic Terminologies

8
 Terminologies
Savings & Investment
Need of Investment
Options available for Investment
Stock Exchange
Equity Market
Equity & Preference Shares
Index
Debt Instruments
Commodities Market

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 Terminologies
Depository
Dematerialization
Sensex
BSE
NSE
Market Capitalisation
Bull Market
Bear Market
IPO

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 Terminologies
Primary & Secondary Market
SEBI
Right Issue and Bonus Shares
Prospectus
Registrar
ADR
GDR
Mutual Funds
Derivatives

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 Derivatives Market

12
 Introduction
Exposure to risk due to fluctuations in prices of
commodities, interest rates, foreign exchange rates,
etc.
Organizations were not able to estimate their costs and
revenues
Derivatives helps control the price volatility
Impact of fluctuations can be minimized by locking-in
asset prices with the help of derivatives productions
A substance that can be made from another substance
Merriam Webster Dictionary
Eg. Curd is a derivate product derived from Milk
The performance of derivatives depends on the
movement in the prices of the underlying assets

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 Derivatives

A derivative is a financial instrument

whose value is derived from the value of
another asset, which is known as the
underlying.

When the price of the underlying

changes, the value of the derivative also
changes.

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 Derivatives

A Derivative is not a product. It is a

contract that derives its value from
changes in the price of the underlying.

Example : The value of a gold futures

contract is derived from the value of the
underlying asset i.e. Gold.

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 Example
An importer in anticipation of adverse
movement in exchange rate may wish to
buy dollars at a future date:
To eliminate the risk of exchange rate
volatility by the due date of making payment
The underlying asset is the spot price of
the dollar
Derivatives, as such, have no value of their
own but derive it from the asset that is
being dealt with

16
 Elements of Derivatives
Contracts
It is a legally binding contract
There are two parties
There is an underlying asset
Future date
Future price

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 Origination of Derivatives
Markets
Traced back to Agriculture markets In traditional market products
were brought and kept in the market the potential buyers would
negotiate the price
Problem: Farmers failed to fetch expected prices and also there was
no availability of storage facilities
Derivatives originated in Chicago Chicago Board of Trade (CBOT)
was established in 1848 to bring farmers and merchants together
Initially its main task was to standardize the quantities and qualities
of the grains that were traded
Within a few years the first futures-type contract was developed. It
was known as a to-arrive contract
Speculators soon became interested in the contract and found
trading the contract to be an attractive alternative to trading the
grain itself
A rival futures exchange, the Chicago Mercantile Exchange (CME),
was established in 1919

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 Types of Underlying
Assets
Financial
Equity Based
Individual Stock (Tata Motors, Infosys, etc,)
Indices (Sensex, Nifty, etc.)
Debt Based
Interest Rates (Libor, T-Bill Rates, etc,)
Credit (Bonds, Loan Receivables, etc.)
Others
Currency (Dollars, GBP, Euro, etc.)
Weather (Temperature, Rainfall Index, etc.)
Emissions (Carbon Credits)

Non-Financial
Agricultural
Cereals, Pulses, Fruits, Vegetables, etc.
Non-Agricultural
Metals, Dairy Products, Animal Products, Energy Products

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 Electronic Markets
Traditionally derivatives exchanges have used what is
known as the open outcry system
This involves traders physically meeting on the floor
of the exchange, shouting, and using a complicated
set of hand signals to indicate the trades they would
like to carry out
Exchanges are increasingly replacing the open outcry
system by electronic trading
This involves traders entering their desired trades at a
key board and a computer being used to match
buyers and sellers
The open outcry system has its advocates, but, as
time passes, it is becoming less and less common

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 OTC Markets
The over-the-counter market is an important alternative to
exchanges and measured in terms of the total volume of
trading, has become much larger than the exchange-traded
market
It is a telephone- and computer-linked network of dealers
Trades are done over the phone and are usually between two
financial institutions or between a financial institution and one
of its clients
A key advantage of the over-the-counter market is that the
terms of a contract do not have to be those specified by an
exchange
Market participants are free to negotiate any mutually
attractive deal
A disadvantage is that there is usually some credit risk in an
over-the-counter trade

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 Participants
HEDGERS
Someone who faces risk associated with
price movement of an asset and who
uses derivatives as means of reducing
risk
They provide economic balance to the
market

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 Participants
SPECULATORS
A trader who enters the futures market for
pursuit of profits, accepting risk in the
endeavor
They provide liquidity and depth to the
market

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 Participants
ARBITRAGEUR
A person who simultaneously enters into
transactions in two or more markets to take
advantage of the discrepancies between
prices in these markets
It involves making profits from relative
mispricing
They help to make markets liquid, ensure
accurate & uniform pricing and enhance
price stability
They help in bringing about price uniformity
24 and discovery
 Economic benefits of
Derivatives
Enhances the price discovery process
Reduces risks - Transfer risks
Witnesses higher trading volumes, because of
participation by more players
More controlled environment
Acts as a catalyst for new entrepreneurial activity
Increase savings and investment in the long run
Lower transaction costs
Enhances liquidity of the underlying asset
Provides signals of market movements
Facilitates financial markets integration

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 Types of Derivatives
Forward
Futures
Options
Swaps

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 Forward Contracts
Forward contract is relatively a simple derivative
It is an agreement to buy or sell an asset
A customized contract between two parties, where
settlement takes place on a specific date in future at a
price agreed today
It can be contrasted with a spot contract, which is an
agreement to buy or sell an asset today
Traded in OTC market
One of the parties to a forward contract assumes a long
position and agrees to buy the underlying asset on a
certain specified future date for a certain specified price
The other party assumes a short position and agrees to
sell the asset on the same date for the same price

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Terminology
Long position - Buyer
Short position - Seller
Spot price Price of the asset in the spot
market (market price)
Delivery/forward price Price of the asset
at the delivery date
 Features of Forward
Contract
They are bilateral contracts and hence exposed to
counter-party risk
Each contract is custom designed, and hence is
unique in terms of contract size, expiration date and
the asset type and quality
The contract price is generally not available in public
domain
The contract has to be settled by delivery of the asset
on expiration date
In case the party wishes to reverse the contract, it has
to compulsorily go to the same counter party, which
being in a monopoly situation can command the price
it wants

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 Example of Forward
Contract
If a farmer plans to grow 100 bushels of wheat
nextyear, he could sell the wheat for whatever the
price is when he harvests it, or he could lock in a price
now by selling a forward contract that obligates him to
sell 500 bushels of wheat to, say, Kellogg after the
harvest for a fixed price. By locking in the price now, he
eliminates the risk of falling wheat prices. On the other
hand, if prices rise later, hewill get only what his
contract entitles to.
In case of Kellogg, they might want to purchase a
forward contract to lock in prices and control the costs.
However, they might end up overpaying or (hopefully)
underpaying for the wheat depending on themarket
pricewhen they take delivery of the wheat.

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 Example of Forward
Contract
Suppose on January 1, 2016 an Indian textile exporter receives an order to
supply his product to a big retail chain in the US
Spot price of INR/US exchange rate isRs.45/dollar.
After six months, the exporter will receive $1 million (Rs 4.5 crore) for his
products.
Since all his expenditure is in rupee term therefore he is exposed to currency
risk.
Lets assume that his cost of production isRs.4 crore. To avoid uncertainty,
the exporter enters into a six-month forward contract with a bank (with some
fees) atRs.45 to a dollar. So the exporter is hedged completely.
If exchange rate appreciates toRs.35 after six months, then the exporter will
receiveRs.3.5 crore after converting his $1 million and the restRs.1 crore
will be provided by the bank.
If exchange rate depreciates toRs.60/dollar then the exporter will
receiveRs.6 crore after conversion, but has to payRs.1.5 crore to the bank.
So no matter what the situation, the exporter will end up withRs.4.5 crore.

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 Futures Contract
A futures contract is an agreement between
two parties a buyer and a seller to buy or
sell something at a future date
The contact trades on a futures exchange and
is subject to a daily settlement procedure
Future contracts evolved out of forward
contracts and possess many of the same
characteristics
Unlike forward contracts, futures contracts
trade on organized exchanges, called future
markets

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 Features of Futures
Contract
There is an agreement
Agreement is to buy or sell the underlying
asset
The transaction takes place on a
predetermined future date
The price at which the transaction will take
place is also predetermined
They are standardized contracts

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Types of Futures Contracts
Stock Futures Trading (dealing with shares)

Commodity Futures Trading (dealing with

gold futures, crude oil futures)

Index Futures Trading (dealing with stock

market indices)
 Example of Futures
Contract
A has bought 1 lot (250 shares) of Reliance July Future @ Rs
700 mean in theory?
It means that the person has agreed to buy 250 shares of
Reliance Industries on 28th July 2016 (the expiration date)
at Rs 700 per share
Here, The underlying is the shares of Reliance Industries;
The quantity is 1 lot, i.e. 250 shares; The expiry date is 28th
July 2016 (last Thursday of July)
The pre-determined price is Rs 700 (and is called the Strike
Price)
If the actual price of Reliance is Rs 800 on the settlement
day (26th July), the person buys 250 shares at the
contracted price of Rs 700 and may sell it at the prevailing
market price of Rs 800 thereby gaining Rs 100 per share (Rs
25,000 in total)
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On the other hand if the price falls to 650 he loses Rs 50 per
share (Rs 12,500 in total) as he has to buy at Rs 700 but the
 OMPARISON
FORWARD FUTURES

Trade on organized exchanges

No Yes

Use standardized contract terms

No Yes

Use associate clearinghouses to

guarantee contract fulfillment
No Yes

Require margin payments and daily

settlements
No Yes

Markets are transparent

No Yes
 Payoffs of Futures Contract
Long Position

37
 Payoffs of Futures Contract
Short Position

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 Options
Futures contract is an obligation to deliver or purchase a
specific commodity as a predetermined time & price
An option is a derivative financial instrument that specifies
a contract between two parties for a future transaction on
an asset at a predetermined time & price
The buyer of the option gains the right, but not the
obligation, to engage in that transaction, while the seller
incurs the corresponding obligation to fulfill the transaction.
Only the purchaser (long position) of the contract gets the
option. The seller (short position) has to obligation to
buy/sell if the option is exercised
Call option gives the holder the right to buy the underlying
asset by a certain date for a certain price
Put option gives the holder the right to sell the underlying
asset by a certain date for a certain price

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 Options - Terminologies
Put Option: A contract in which option buyer has right to sell
underlying asset at the exercise price
Call Option: A contract in which option buyer has right to
buy underlying asset at the exercise price
Option Buyer/Holder: A person who buys an option to either
buy (call option) or sell (put option) underlying asset
Option Seller/Writer: A person who sells/writes a call or a
put option to option buyer. He/she has the obligation to buy
(in case of put option wrote) or to sell (in case of put option
wrote), if the holder of option decides to exercise his option
Exercise/Strike Price: It is the pre-decided price at which
option buyer is eligible to buy or sell the underlying asset
Expiration/Maturity date: Last day on which option can be
either exercised or lapsed
Exercise Date: The date on which the option is actually
40 exercised

 Options - Terminologies
In-the-Money (ITM): An option is ITM, when exercising
option is favorable
In case of Call option, when ruling spot price (S) exceeds
Exercise Price (X), the option is ITM i.e. S >X
In case of Put option, when ruling spot price (S) is less than
Exercise Price (X), the option is ITM i.e. S<X
Out-of-the-Money (OTM): When exercising of option is
not favorable
In case of Call option, S<X and in case of Put Option, S >X
At-the-Money (ATM): When exercising option is neither
favorable nor unfavorable
IN case of both call and put option S=X
Intrinsic Value (IV): Amount by which an option is ITM
IV of call option (IVc)=Current price of underlying asset(S)-
Exercise Price(X)=S-X
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IV of put option (IVp)=Exercise Price(X)-Current price of
 Options - Terminologies
Option Class: All listed options of particular type (i.e. put or call) on a
particular underlying asset (Eg. All put or call options on S&P CNX Index)
Option Series: All the options of a given class having same Expiration
Date and Exercise Price. (Eg. OPTIDX NIFTY 29JUL 2010 PE 5400 is an
option series which includes all S&P CNX Nifty Put Options that are traded
with Exercie Price of 5400 and expiry 29 July 2010
Open Interest: The total number of options contracts outstanding in the
market at any given point in time
Futures Option: An option contract in which underlying asset is a futures
contract
Covered Call: When an option writer writes a call option which is covered
by a position in underlying asset, it is referred to as covered call
Eg. An option writer writes a call option on shares of ABS Ltd while holder
the shares of ABS Ltd, if the option buyer exercises the option, the writer
will be in a position to delivery the underlying
Naked Call: Involves writing a call option without holder the underlying

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 Options Types
On the basis of timing of Exercisability:
American options: Can be exercised at any time up to
the expiration date
European options: Can be exercised only on the
expiration date itself
A Bermuda (Mid Atlantic) option: Has several potential
exercise dates over the life of the contract (monthly,
quarterly, etc) commonly used in interest rate and
foreign exchange markets
On the basis of way they are traded:
OTC Options
Exchange Traded Options
On the basis of underlying:
Commodities
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Equities and Indices based on equities
 Futures Vs. Options
Payoffs: Futures have linear payoffs (i.e. the profits/losses of the
buyers and sellers are unlimited); Options have non-linear
payoffs( i.e. the loss of the option buyer is limited and profits
potentially unlimited, whereas profits of option writer is limited and
loss potentially unlimited)
Performance Obligation: In futures, there is obligation on both the
buyers and sellers; In options, the obligation is only on option writer
Trading: Futures are usually Exchange traded; Options are both
Exchange traded and OTC
Premium: Not required for Futures; In case of Options, Buyer pays
premium to the Writer
Margin: Exchange specified margin is required to be deposited by
both buyer and seller; Only Writer has to deposit exchange specified
margin
Settlement: For Futures, it is daily on exchange; In American option
on daily basis, European & Bermudan option only on specified date/s.

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 Moneyness of Options
Moneyness of an option illustrates the
relationship between the spot price and the
exercise price of the option
It explains how the option holder would
benefit if the holder exercises the option
Three types of moneyness of options are:
ITM
ATM
OTM

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 Moneyness of Options
Call Option Put Option Cash Flows if
Exercised
ITM S >X S<X Positive
ATM S=X S=X Nil
OTM S<X S >X Negative

46
 Illustration
In July 2015, Mr.Manibhai purchased a September Call
Option on the Stock of ABC Ltd. at an exercise price of
Rs.1150 and a September Put Option on XYZ Ltd. at an
exercise price of Rs.520. If the prices of the shares of
both the companies in the month of September 2015
are as given below. What is the moneyness of options?
Show cash flow computations.

Possibilities ABC Ltd. XYZ Ltd.

A 1170 510
B 1150 520
C 1130 530

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 Solution
Possibiliti ABC Ltd. XYZ Ltd.
es
Cash Flow Moneyn Cash Moneyne
ess Flow ss
A 1170- ITM 520- ITM
1150=20 510=10
B 1150- ATM 520-520=0 ATM
1150=0
C 1130- OTM 520-530=- OTM
1150=-20 10

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 Option Payoffs
The option has non-linear payoffs
The loss of the option buyer is limited to
the extent of premium paid and profit
potential is unlimited
For option writer, the profit is limited to
extent of premium received and loss
potentially unlimited
Call option Buyer; Call option Writer; Put
option Buyer; Put Option Writer

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 Option Premium
Options are uneven contracts that give right to one i.e.
option buyer, while bind the other party i.e. option writer
The option writer gets bound to the contract for a
consideration (price) option price or premium
Option buyer/holder has to pay a price for acquiring this
right to buy or sell the underlying assets on pre-agreed
terms and the price of this right without obligation is
Option Price
Option premium is paid by Option buyer for both call as
well as Put Option to the option writer
It is a cash outflow for option buyer and inflow for writer
It will reduce the profit of buyer and reduce the loss of
writer

50
 Factors affecting Option
Premium
Quantifiable Factors
Spot price of Underlying
Exercise Price
Volatility of Underlying Assets
Time to Expiration
Risk-Free Interest Rate
Non-Quantifiable Factors
Participants perception about future volatility in
prices of underlying assets
Effect of demand-supply situation of underlying
both in derivatives and cash segment
Trading volume in the market

51
 Option Payoffs
Illustration
There is a European call option on stock of
ABC Ltd
Paying option premium of Rs.3, having
exercise price of Rs.50
Spot prices at expiry of Rs.46, 4755
Calculate Intrinsic Value and P/L for:
Call Option Buyers Payout
Call Option Writers Payout
Put Option Buyers Payout
Put Option Writers Payout

52
 Call Option Buyers Payoff
Exercise Spot Price Intrinsic Call Profit or
Price Value Premium Loss
Paid
X S IV Cpr P/L
50 46 0 -3 -3
50 47 0 -3 -3
50 48 0 -3 -3
50 49 0 -3 -3
50 50 0 -3 -3
50 51 1 -3 -2
50 52 2 -3 -1
50 53 3 -3 0
50 54 4 -3 1
53 50 55 5 -3 2
 Call Option Buyers Payoff
6

5 5

4 4

3 3

2 2 2
Intrinsic Value
1 1 1
Profit or Loss
0 0 0 0 0 0 0
46 47 48 49 50 51 52 53 54 55
-1 -1

-2 -2

-3 -3 -3 -3 -3 -3

-4

54
 Call Option Writers Payoff
Exercise Spot Price Intrinsic Call Profit or
Price Value Premium Loss
Received
X S IV Cpr P/L
50 46 0 3 3
50 47 0 3 3
50 48 0 3 3
50 49 0 3 3
50 50 0 3 3
50 51 -1 3 2
50 52 -2 3 1
50 53 -3 3 0
50 54 -4 3 -1
55 50 55 -5 3 -2
 Call Option Writers Payoff
4

3 3 3 3 3 3

2 2

1 1

0 0 0 0 0 0 0
46 47 48 49 50 51 52 53 54 55 Intrinsic Value
-1 -1 -1
Profit or Loss
-2 -2 -2

-3 -3

-4 -4

-5 -5

-6
56
 Put Option Buyers Payoffs
Exercise Spot Price Intrinsic Put Profit or
Price Value Premium Loss
Paid
X S IV Ppr P/L
50 46 4 -3 1
50 47 3 -3 0
50 48 2 -3 -1
50 49 1 -3 -2
50 50 0 -3 -3
50 51 0 -3 -3
50 52 0 -3 -3
50 53 0 -3 -3
50 54 0 -3 -3
57 50 55 0 -3 -3
 Put Option Buyers Payoffs
5

4 4

3 3

2 2

1 1 1 Intrinsic Value IV
0 0 0 0 0 0 0 0 Profit or Loss P/L
46 47 48 49 50 51 52 53 54 55
-1 -1

-2 -2

-3 -3 -3 -3 -3 -3 -3

-4

58
 Put Option Writers Payoffs
Exercise Spot Price Intrinsic Put Profit or
Price Value Premium Loss
Received
X S IV Ppr P/L
50 46 -4 3 -1
50 47 -3 3 0
50 48 -2 3 1
50 49 -1 3 2
50 50 0 3 3
50 51 0 3 3
50 52 0 3 3
50 53 0 3 3
50 54 0 3 3
59 50 55 0 3 3
 Put Option Writers Payoffs
4

3 3 3 3 3 3 3

2 2

1 1

0 0 0 0 0 0 0 0
Intrinsic Value
46 47 48 49 50 51 52 53 54 55
Profit or Loss
-1 -1 -1

-2 -2

-3 -3

-4 -4

-5

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What are 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.

Some are also traded on futures exchange

market.
Types of Swaps
There are 2 main types of swaps:

Plain vanilla fixed for floating swaps

or simply interest rate swaps.

Fixed for fixed currency swaps

or simply currency swaps.
What is an Interest Rate Swap?
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.
Floating Interest Rate
LIBOR London Interbank Offered Rate
It is the average interest rate estimated by
leading banks in London.
It is the primary benchmark for short term
interest rates around the world.
Similarly, we have MIBOR i.e. Mumbai
Interbank Offered Rate.
It is calculated by the NSE as a weighted
average of lending rates of a group of
banks.
 Interest Rate Swap Example
LIB LIBOR
SWAPS
Co.A
OR

8%
BANK
8.5%
Co.B
Aim - Aim -
VARIABLE FIXED

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

Bank Bank
Fixed
A Fixed
B
7% 10%
Variable Variable LIBOR
LIBOR + 1%
Using a Swap to Transform a
Liability
Firm A has transformed a fixed rate liability
into a floater.
A is borrowing at LIBOR 1%
A savings of 1%

Firm B has transformed a floating rate liability

into a fixed rate liability.
B is borrowing at 9.5%
A savings of 0.5%.

Swaps Bank Profits = 8.5%-8% = 0.5%

What is a Currency Swap?
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

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

$60t
h
7% 40 5%
th

Bank A Bank B

6% 5%
$ $
7% 8%
Comparative Advantage
Firm A has a comparative advantage in
borrowing Dollars.

Firm B has a comparative advantage in

borrowing Euros.

This comparative advantage helps in

reducing borrowing cost and hedging
against exchange rate fluctuations.