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DERIVATIVES AN

OVERVIEW

- Prof. Geetika Gahlot

RISK MANAGEMENT
Risk can be defined as deviation of the actual results
from the expected.
Measurement of risk is determined by the combined
impact of the probability and magnitude of loss, i.e.,
product of the two.
Risk can be viewed in two ways:
Risk of small losses with high probability
Risk of large losses with low probability

Different ways to manage risk include:


Controlling potential damage.
Diffusing the risk across sources.
Diversification of risk through portfolio management.
Transferring risk to another party who is willing to
accept it.

Hedging refers to the management of risk through


transfer from those who prefer to avoid it to those who
are willing to bear it.

Types of Business Risk


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

DERIVATIVES
Derivatives are instruments that derive their value on the
basis of prices of some other asset, called underlying
asset.

These underlying assets can be physical commodities or


financial securities or may be notional that are devoid of
physical substance but have financial implications.
In other aspects derivatives may remain distinctly
different from and independent of the underlying asset.

Derivative Products
Variety of derivatives are available; both standard
products that are traded on an exchange as well as tailormade, to suit various applications.
Four broad types of derivative instruments are:
Forwards,
Futures,
Options, and
Swaps.
Besides basic products other complex products such as
swaptions, options on futures etc. are also available.

Derivative and Diversification


Diversification eliminates unsystematic risk.
Derivatives can eliminate systematic risk.
Managing risk of a diversified portfolio through
derivatives renders portfolio risk free, because both risks
systematic and unsystematic are eliminated and
hence portfolio is risk free earning only risk free return.
Diversification and derivatives used simultaneously can
at best be a temporary strategy when the market risk of
the portfolio exceeds risk appetite of the investors.

Derivative and Insurance


Insurance eliminates event risk i.e. risk of high losses
with low probability.
Derivatives can eliminate business risk i.e. the risk of
small losses with high probability.
Managing risk with insurance requires a) payment of
premium, b) proof of event having taken place, and c)
compensation not exceeding the loss.
Risk management with derivatives does not have any
such requirements as market pays; the happening of loss
is immaterial

Derivative and Strategic Risk


Strategic risk management is expensive, irreversible, time
consuming and long term.
Risk management with derivatives is:
Quick
Reversible
Inexpensive
Short term

Types of Derivatives
Based on Product:
Forwards
Futures
Options
Swaps

Based on Trading:
Over-the Counter contracts
Exchange-traded contracts

Based on Underlying Asset:


Commodities
Currencies
Shares/Indices
Interest Rates
Credit
Weather

Types of Participants
Hedgers: Those who use derivatives for hedging i.e.
reduce or eliminate risk.
Speculators: Those who take positions in derivatives to
increase returns by assuming increased risk. They
provide much needed liquidity to markets.
Arbitrageurs: Those who exploit mispricing in
different markets; They assume riskless and profitable
positions.
All 3 participants
functioning.

are

essential

for efficient

Functions of Derivatives
Three functions of derivatives:
Enable price discovery
Facilitate transfer of Risk
Provide Leverage

Criticisms of Derivatives
Increased volatility: Though used for efficient price
discovery, derivatives when used as a speculative
product can cause increased volatility in spot prices.
Increased bankruptcies: Derivatives being leveraged
products enable taking disproportionate positions and
have led to several disasters and bankruptcies.
Increased burden of regulations: Derivatives
transactions hide more than what they reveal, as they
escape accounting. For financial discipline and better
disclosures new rules have to be devised by regulators.