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CHAPTER 1

DERIVATIVES AN INTRODUCTION
Derivatives and Risk Management By Rajiv Srivastava Copyright Oxford University Press

Risk
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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 occurrence and 2) risk of large losses with infrequent occurrence. 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.
Copyright Oxford University Press

Derivatives and Risk Management By Rajiv Srivastava

Chapter 1 Derivatives An Introduction

Managing Risk
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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 enable offsetting of risk emanating from one situation.
Copyright Oxford University Press

Derivatives and Risk Management By Rajiv Srivastava

Chapter 1 Derivatives An Introduction

Types of Risks
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Business risks are characterised by small losses but with high probability The risk of large losses with small probability is normally referred as event risk. Event risk is normally managed by insurance. companies and Business risk is concerned about
Changes in prices, Changes exchange rates, and Changes in interest rates.

Derivatives and Risk Management By Rajiv Srivastava

Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Derivatives
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Three kinds of business risk of price, exchange rate and interest rate can be managed through products that are classified as 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.

Derivatives and Risk Management By Rajiv Srivastava

Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Derivative Products
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Variety of derivatives are available both standard product as well as tailor-made, to suit various applications. Four broad types of instruments are:
Forwards Futures Options, Swaps,

and

Derivatives and Risk Management By Rajiv Srivastava

Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Classification of Derivatives
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Based on the underlying asset

Based on how traded

The underlying asset can be Commodities Currencies Shares/Indices Interest Rates Credit Weather
Derivatives and Risk Management By Rajiv Srivastava

Derivatives can be traded either on the exchange or OTC Over-the-counter (OTC) Exchange Traded

Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Participants in Derivative Markets


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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 different markets; They assume riskless and profitable positions. All 3 participants are essential for efficient functioning.
Derivatives and Risk Management By Rajiv Srivastava
Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Functions of Derivatives
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3 major functions of derivatives are: Enable price discovery Facilitate Transfer of Risk Provide Leverage

Derivatives and Risk Management By Rajiv Srivastava

Copyright Oxford University Press

Chapter 1 Derivatives An Introduction

Misuses & Criticism of Derivatives


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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 they reveal. For financial discipline and better disclosures new rules have to be devised.
Copyright Oxford University Press

Derivatives and Risk Management By Rajiv Srivastava

Chapter 1 Derivatives An Introduction