An Introduction
By RAJIV SRIVASTAVA
RISK DEFINED
Risk, in traditional terms, is viewed as a negative. Websters dictionary,
for instance, defines risk as exposing to danger or hazard.
The Chinese give a much better description of risk
The first is the symbol for danger, while
The second is the symbol for opportunity,
Making risk a mix of danger and opportunity.
Great Line by Mr. Ratan Tata in one of his speeches:
"The ups and downs in life are equally important to keep us going,
because a straight line, even in an E.C.G. means we are not alive."!
Derivatives and Risk Management
Rajiv Srivastava
RISK Specifically defined
Risk can be defined as deviations of the actual results
from expected.
Risk can be classified 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
1. The probability of an adverse event happening, and
2. In case the event occurs the magnitude of the loss it
can cause.
Derivatives and Risk Management
Rajiv Srivastava
CLASSIFICATION OF RISK
PROJECT RISK
FINANCIAL RISK
Operational
Price Risk
Currency Risk
Regulatory
Quantity Risk
Political
Interest Rate Risk
Liquidity
Human Resource
Can only be managed by
precautions in appraisal
Event specific risk are
managed by insurance.
Credit/Default Risk
Portfolio Risk
Derivatives and Risk Management
Rajiv Srivastava
Mostly managed by financial
tools such as diversification
and through derivatives.
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CLASSIFICATION OF RISK
SYSTEMATIC/MARKET RISK
UNSYSTEMATIC RISK
Risk specific to a group of
Risk specific to a particular
assets, or the industry or the
market as a whole.
Cannot be managed by
diversification but can be
managed by derivatives.
Derivatives and Risk Management
Rajiv Srivastava
asset.
Can be managed by
diversification to a desirable
extent but cannot vanish
altogether.
Some element of risk remains
after diversification.
CLASSIFICATION OF RISK
EVENT RISK
BUSINESS RISK
Risk of large losses with small
Risk of small losses with large
probability such as
earthquake, tsunami, riots,
terrorism etc.
May affect large number of
firms/individuals.
Can be managed by insurance
if such policies are available.
probability such as price risk,
exchange rate risk, interest
rate risks specific to a
particular firm.
May affect large number of
firms/individuals.
Can be managed by
derivatives.
Derivatives and Risk Management
Rajiv Srivastava
MANAGING RISK
The ways to manage risk include attempt to control
potential damage, diffuse, diversify and transfer risk
to those willing to accept it.
One can manage the risk by transferring it to
another party who is willing to assume risk.
Insurance company does not do anything to contain
the risk per se but assumes risk on your behalf.
Management of risk through derivatives is
commonly referred as hedging which enables
offsetting of risk emanating from a situation.
Derivatives and Risk Management
Rajiv Srivastava
STRATEGIC AND TACTICAL RISK
MANAGEMENT
The business risks of
1. price,
2. exchange rate, and
3. interest rate as also the credit risk
can be managed through derivatives.
Management of risk through derivatives is tactical as
distinct from strategic management.
Strategic management is costly, mostly irreversible, time
consuming and requires several opinions.
Derivatives and Risk Management
Rajiv Srivastava
DERIVATIVES
Derivatives are 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.
Management of risk through derivatives in contrast to
strategic management of risk is
quick,
2. economical,
3. reversible, and
4. mostly provides protection in the short term.
1.
Derivatives and Risk Management
Rajiv Srivastava
WHY MARKET FOR DERIVATIVES
If the prices of derivatives are linked to the physical market
then why have derivatives as separate instrument?
Spot/Physical Market
Price from Spot Market
Derivatives
Market
Enables take separate, independent and opposite
positions in two different markets.
If prices move in tandem opposite positions in two markets
in makes hedging feasible.
Derivatives and Risk Management
Rajiv Srivastava
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TYPES OF DERIVATIVES
Variety of derivatives are available both as standard
product and tailor-made, to suit various applications.
Four broad and basic types of instruments are:
Forwards
Futures
Options, and
Swaps,
Combinations of derivatives are also available such as
options on futures, swaptions etc for more complex
applications.
Derivatives and Risk Management
Rajiv Srivastava
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TYPES OF DERIVATIVES
Based on the underlying asset
The underlying asset can be
Commodities
Financial
Currencies
Shares/Indices
Interest Rates
Credit
Others
Weather
Energy
Derivatives and Risk Management
Rajiv Srivastava
Based on how traded
Derivatives can be traded
either on the exchange or OTC
Over-the-counter (OTC)
Forwards,
Options,
Swaps
Exchange Traded
Futures,
Options
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PARTICIPANTS IN
DERIVATIVE MARKETS
Hedgers: are those who use derivatives for hedging i.e.
reduce or eliminate risk.
Speculators: are those take positions in derivatives to
increase returns by assuming increased risk. They
provide much needed liquidity to markets.
Arbitrageurs: are those who exploit mispricing in two
different markets; They assume riskless and
profitable positions unlike speculators.
All 3 participants are essential for efficient functioning.
Derivatives and Risk Management
Rajiv Srivastava
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FUNCTIONS OF
DERIVATIVES
3 major functions of derivatives are:
Enable price discovery because two independent
markets are available for the same asset. It increases
participation making markets deep. If derivatives are
exchange traded then transparent prices are available
worldwide.
Facilitate transfer of risk from those trying to avoid to
those prepared to assume risk.
Provide leverage to attract speculators to participate and
increase market depth enabling fair price.
Derivatives and Risk Management
Rajiv Srivastava
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CRITICISM OF
DERIVATIVES
Increased volatility: Though used for efficient price discovery,
derivatives when used as a speculative product can make increase
volatility in prices.
Increased bankruptcies: Derivatives being leveraged products have
caused disproportionate positions leading to several disasters and
bankruptcies.
Increased burden of regulations: Most derivatives hide more than
what they reveal, liabilities being contingent in nature. For financial
discipline and better disclosures new rules have to be devised.
Double-edged sword: If used judiciously it provides risk mitigation
but if used injudiciously it magnifies risk.
Derivatives and Risk Management
Rajiv Srivastava
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Rajiv Srivastava
rajiv1234@[Link]
Derivatives and Risk Management
Rajiv Srivastava
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