Derivatives and

Risk Management

Abhinav Rajverma
 Topics

Why Manage Risk?

Derivatives: Introduction
Derivatives: Forwards
Forwards vs. Futures
Hedging Using Futures

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 Risk Management
Financial Risk
Liquidity Risk: CR, QR, Cash Ratio
Financial Distress: ICR, DSCR
Bankruptcy Risk
Information Asymmetry
Agency Problems
Reputational Risk

Economic Risk Uncertainty Risk

Loss of Sales Price Volatility
Recession etc. Interest Rate Volatility

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 Why Manage Risk?
Risk Management: Relevance
Better Financial Planning
Focus on the Core Business
Improved Performance
Value Maximization

Identify Risk

Avoid Accept Reduce Transfer

Hedging
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 Derivative: Introduction
A financial contract that derives its value from
underlying assets.

Role of Derivatives Common Derivatives

 Risk Management  Forwards
 Price Discovery  Futures
 Operational Advantages  Options
Low transaction cost  Swaps
Improved liquidity
Ease in selling (short)
 Enhanced Market efficiency

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 Derivatives: Advantages
Neither create nor destroy wealth: Means to transfer risk
Zero-sum game – One’s gain is equal to another’s loss
One can choose the risk level willing to take
Efficient allocation of risk – Investors supply more funds to
the financial markets; thus, enables a firm to raise capital
at reasonable costs

Derivatives are powerful instruments

Have high degree of leverage and small price changes can
lead to large gains and losses
High degree of leverage makes them effective but also
‘dangerous’ when misused.

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 Viewpoints!!

“In our view, however, derivatives are financial weapons of

mass destruction, carrying dangers that, while now latent, are
potentially lethal.”
Warren Buffett, 2002 Berkshire Hathaway AR

“Derivatives are something like electricity: dangerous if

mishandled but bearing the potential to do good.”
Arthur Leavitt, Chairman SEC 1995

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 Derivatives: Usage
Usage: Hedging Risk, Speculation, Arbitrage

Why Hedging?
 Focus on the main business
 Minimize risks arising from interest rates, exchange rates, and
other market variables
 Volatility in commodity prices
 Aluminum futures (MCX) – 25% annualized
 Zinc futures (MCX) – 24% (annualized)
 Crude oil futures (MCX) – 33 % (annualized)
 Mitigates risk of unfavorable price change
 Commodity price can be locked by hedging
Note: Loses profit opportunity (favorable price change) – Prices are
locked (futures)

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 Example: Arbitrage
Example: A stock price is quoted as £100 in London and $152 in
New York. The current exchange rate is $1.5500 per pound. What
is the arbitrage opportunity?
Solution:
Value of stock in London = £100 = $155
Value of stock in New York = $152
“Buy low sell high”
Arbitrage opportunity: Buy in New York and sell in London.

Problem: An investor enters a short forward contract to sell

100,000 British pounds for USD at an exchange rate of 1.90 U.S.
dollars per pound.
How much does the investor gain or lose if the exchange rate at
the end of the contract is: (a) 1.89 (b) 1.92

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 Derivatives: Criticism

Criticism
 Used for speculation rather than hedging
 Too complicated
 Scams and losses
2007 Financial Crisis
Nick Leeson and the Barings Bank (1995)

https://www.youtube.com/watch?v=kvuOt7PK92c

https://www.youtube.com/watch?v=BXcXVjfI_y0

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 Forward Contracts
Characteristics
Buy/Sell: Obligation
Maturity date
Strike price
Quality
Place of delivery

Position
Long position: Obligation to buy in future
Short Position: Obligation to sell in future

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 Example: Forward Contract
Problem: A farmer expects to harvest 100 MT of mangoes in
June. A trader needs to supply mangoes to the Azadpur Mandi.
How can the two use the forward contract for hedging?

Solution:
Farmer and trader strike a deal
Trader agree to buy 100 MT of mangoes at INR 25,000 per MT to
be paid on delivery in June
Farmer agrees to deliver 100 MT of mangoes at INR 25,000 per
MT in June.

Forward Contract:
Counter parties: Farmer and Trader
Position: Trader is long, and Farmer is short
Settlement price: INR 25,000 per MT
Quantity: 100 MT
Price: Fixed today, but payment and delivery later in June
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 Forwards versus Futures
Forwards
 Custom made
 Over-the-counter traded
 Counterparty risk
Coca-Cola to supply Coca syrup to its bottlers at a
constant price forever
Futures
 Standardized
 Exchange-traded
 Margin requirement
 Marked-to-market

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 Marked-to-Market in Futures
Advantages
 Reduces counterparty risk
 Reduces administrative overheads for exchanges
 Reduces credit risk
Drawbacks
 Requires robust monitoring system
 Cause of concern – high price volatility

Initial Margin

Maintenance Margin

Margin Call
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 Basic Principle: Hedging Using Futures
1. When is a short future position appropriate?
2. When is a long future position appropriate?
3. Which future contract should be used?
4. Optimal size of future contracts for reducing risk?
Short Hedge
Involves a short position in Futures
Appropriate when the hedger owns an asset and expects to sell
it at some time in future
If not owned, will be owned in future on/before the expiry of
future contract
Long Hedge
Involves a long position in Futures
Appropriate when the hedger is certain of buying the asset in
future and wants to lock a price now
Can be used to manage an existing short position.

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 Example: Short Hedging
Example: Its July and a farmer expects to harvest 10,000 MT of
paddy in December month. The paddy futures is for 10 MT of paddy.
How can the farmer use the futures contract for hedging?
July month:
 Objective (of farmer): Sell paddy after harvesting
 Strategy: Long/Short paddy futures
 Appropriate lot size: 10,000/10 = 1,000
 Appropriate contract: Nov/Dec/Jan
 If Nov: Delivery in November; yet to be harvested
 If Jan: Storage cost; harvesting in Dec
Jan contract, if expect delay in harvest, liquidity risk
 Positions in future market can be cash settled
December month: After harvest
1. Deliver to buyer in December (10,000 MT paddy)
2. Sell the produce in the local market and close future position by taking
opposite position (long) in the future market (1000 lot)

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 How are prices locked?
Particulars Situation A Situation B
Prices Locked (July) INR 20/kg (F1) INR 20/kg (F1)
Expense (expected) INR 15/kg INR 15/kg
Farmer’s Position Short Short
Event Good monsoon Bad monsoon
Impact High production Low production
Dec: Spot Price in local market (SP) INR 5/kg INR 40/kg
Buying Price in Dec: When position is INR 5/kg (F2) INR 40/kg (F2)
closed in the futures market
Gain(loss) in futures (F1-F2) 15 (-20)
Value realized = SP + gain(loss) 5 + 15 = 20 40 + (-20) = 20
Profit (per Kg) 20 – 15 = 5 20 – 15 = 5
No hedging: Profit (per Kg) 5 – 15 = (-10) 40 – 15 = 25

Is hedging beneficial for a rational farmer? 17

 Example: Long Hedging
Problem: Indigo requires 20,000 Kl of Jet fuel in November. The
crude oil futures is for 1000 Kl. Assume, the price volatility of
Jet fuel to be twice of crude oil price volatility. Discuss hedging
strategy using futures.
March month:
 Objective (of Indigo): Buy Jet fuel for consumption in Dec
 Strategy: Long/short in crude oil futures (close substitute)
 Lot size: 20,000/1000 * SD(Jet fuel) / SD(Crude oil) = 40
 Appropriate contract: Oct/Nov/Dec
 If Oct: Storage cost for Indigo
 If Nov: As cash settled, liquidity risk
Nov month:
 Buy Jet fuel from the local market
 Close future position
For airline industry, Jet fuel is the second largest expense after labor

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 Discussion: Long Hedging
Particulars Situation A Situation B
March month Long position Long Position
Crude oil futures – Nov contract (INR/Ltr) Z (F1) Z (F1)
Expected ATF price in Nov (INR/Ltr) K K
Volatility - ATF vs. Crude oil (Hist.) 2:1 2:1
Event (say around Aug-Sept) Price war among Terror attack
OPEC (OPEC)
Impact High Production Low production
November month
Price in local market (crude oil) Z–x Z+y
Price in local market (ATF) K – 2x K + 2y
Price: crude oil Nov futures (ignoring storage cost) Z-x Z+y
Gain (loss) in futures market (close position) - x * 40 (loss) y * 40 (gain)
ATF cost (spot market in million rupees) (K-2x) * 20 (K+2y) * 20
Net amount paid (millions rupees) 20K 20K

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 Takeaways

Derivatives and Risk Management

Need for risk management
Managing risks using derivatives
Common types of derivative
Forwards versus Futures
Marked-to-market and its relevance
Hedging using futures

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 Practice Problems: Hedging
1. A farmer expects to harvest 10,000 MT of wheat in three
months. The Wheat Futures on NCDEX is for 10 MT of
wheat. How can the farmer use the futures contract for
hedging?
2. It is April and Anand Chemicals need 50,000 barrels of
crude oil in July. The Crude Oil Futures is for 1000
barrels. How can the firm use the futures contract for
hedging?
3. A firm plans to buy 20,000 barrels of crude oil in August.
One future contract is for delivery of 1000 barrels. The
current Sept. Oil Futures price is $58 per barrel. Discuss
the firm strategy if Spot Price and Sept. Futures price on
August 15 are $65 and $62, respectively.

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 Interest Rate Hedging
Problem: It is April 2025. A small home financing (SHF) firm
makes a commitment to lend Rs. 1000 crores (in aggregate) to
2000 home loan seekers on July 1 for 10% fixed interest rate
for 20-year period. The SHF plans to sell the loan portfolio to
a large home financing firm (LHF) by June 30. Discuss the
appropriate hedging strategy for SHF to mitigate the interest
rate risk.
April Month:
Objective (of SHF) : To raise fund from LHF by selling (offering) future
cash flow (from home loan seekers) for the next 20 years

PV of CFs = + …….+
Interest rate risk?

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 Solution: Interest Rate Hedging
April 2025:

Objective (of SHF) : Sell future CFs (20 years) to LHF

Strategy:
 Search for a close substitute (of future CFs) – Say Gsec
 Appropriate size and duration
 Long/Short the close substitute (Gsec futures)

June 15: Was able to sell the future CFs to an LHF

 Close position in the futures market (Long Gsec futures)

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 How is interest rate risk hedged?

Particulars Situation A Situation B

April – Interest Rate (fixed) 10% 10%
PV of Future CFs (20 years) 1000 1000
Short 20 years Gsecs (≈ 1000) (≈ 1000)
June 15
Interest rate (fixed) 12% 9%
Loan sold to LHF (spot
market) (<1000; say 900) (>1000; say 1050)
Long 20-years G-sec (futures) (≈ 900) (≈ 1050)
Gain from position in futures 100 -50
Total fund realized 900+100 = 1000 1050 – 50 = 1000

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Thank You
for
Your Time

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