Derivatives and Risk Management
Unit 1:
RISK MANAGEMENT
Introduction :
Risk
Risk can be defined as the chance of loss or an unfavourable outcome associated with an action. Uncertainty does not know what will happen in the future, the greater the uncertainty, the greater the risk.
Definition of Risk Management :
1) Risk management is an integrated process of delineating (define) specific areas of risk, developing a comprehensive plan, integrating the plan, and conducting the ongoing evaluation’ – Dr. P.K. Gupta.
2) Risk Management is the process of measuring, or assessing risk and then developing strategies to manage the risk’ – Wikipedia.
3) Managing the risk can involve taking out insurance against a loss, hedging a loan against interest rate rises, and protecting an investment against a fall in interest rates’ – Oxford Business Dictionary
Unit 2-Derivative instruments-Forward and Future
Process of Risk Management
The Five Essential Steps of a Risk Management Process are:
Step 1: Identify The Risk- The initial step in the risk management process is to identify the risks that the business is exposed to in its environment.
Step 2: Analyse The Risk- Once a risk has been identified it needs to be analysed. The scope of the risk must be determined. It is also important to understand the effect of the risk on different factors within the organisation.
Step 3: Evaluate The Risk Or Risk Assessment- Risks need to be ranked and prioritised. Most risk management frameworks have different categories of risks, depending on the severity of the impact of the risk. A risk that may cause little inconvenience is rated the lowest, and risks that can result in greater loss are rated the highest. There are two types of risk assessments: Qualitative Risk Assessment and Quantitative Risk Assessment.
Step 4: Treat The Risk-Every risk needs to be eliminated or controlled as much as possible. This is done by the experts in the field to which the risk belongs.
Step 5: Monitor And Review The Risk- Not all risks can be eliminated. Market risks and environmental risks are just two examples of risks that always need to be monitored. It is important to make sure to keep a close watch on all risk factors.
Types of Risks.
There are three types of risks-business risk, financial risk and portfolio risk. Details in this regard are as follows:
1 Business Risk. Business risks are the risks which are related with the production, marketing and personnel affairs of a business firm. A firm has to face the risks at every step such as- tastes and preferences of customers, policies of competitors, quality and price of the products of competitors, business cycles, labour strikes, pricing policy of the firm etc. When uncertainty in this regard is measurable, it becomes business risk.
2. Financial Risk. Financial risks are the risks related with financial activities and decisions of a firm. Financial decisions determine the financial risk of a firm. Financial risks relate to the risk of possible fluctuations in the profit, risk of bad debts and the risk of possible insolvency etc. Effect of financial risks is reflected in the prices of shares.
3. Portfolio Risk. Portfolio risks are the risks that are derived from various investment proposals and their effect on the financial structure of a firm. Such risks are insurable.
There are also other forms of risk such as
1. Credit Risk (also known as Default Risk) Credit risk is just the risk that the person you have given credit to, i.e. the company or individual, will be unable to pay you interest, or pay back your principal, on its debt obligations
2. Country Risk When a country cannot keep to its debt obligations and it defaults, all of its stocks, mutual funds, bonds and other financial investment instruments are affected, as are the countries it has financial relations with.
3. Political Risk It is the risk that a country's government will suddenly change its policies. For example, today with the continuing raging debate on FDI in retail, India's policies will not be looking very attractive to foreign investors, and stock prices are negatively affected.
4. Reinvestment Risk This is the risk that you lock into a high yielding fixed deposit or corporate deposit at the highest available rate , and when your interest payments come in, there is no equivalent high interest rate investment avenue available for you to reinvest these interest proceeds (for example if your interest is paid out after 1 year and the prevailing interest rate is 8% at that time).
5. Interest Rate Risk A golden rule in debt investing is this: Interest Rates go up, prices of bonds go down. And vice versa. This means that since interest rates are going to go down from here, prices of bonds are going to go up.
6. Foreign Exchange Risk Forex risk applies to any financial instruments that are denoted in a currency other than your own. With the recent very sharp fall in the rupee, the forex risk of our country as an investment destination has greatly increased.
7. Inflationary Risk -Inflationary risk, or simply, inflation risk, is when the real return on your investment is reduced due to inflation eroding the purchasing power of your funds by the time they mature.
8. Market Risk This is the risk that the value of your investment will fall due to market risk factors, which include equity risk (risk of stock market prices or volatility changing), interest rate risk (risk of interest rate fluctuations), currency risk (risk of currency fluctuations) and commodity risk (risk of fluctuations in commodity prices).
notes of unit 2-Derivative instruments-Forward and Future
Objectives of Risk Management
- Ensure the optimal, balanced, and sustainable performance of the company
- Develop a comprehensive, systematic, integrated, and flexible approach. Thus identifying, assessing, analyzing, and managing risks
- Develop better risk management practices
- Address all types of business risks
- Take responsible risks
- Make informed decisions
- Better manage change
Uncertainty
Uncertainty is just opposite to the situation of certainty. Uncertainty is a situation in which the result of various decisions cannot be predicted and their probability can also not be measured.
Definitions for uncertainty has been defined as under:
“Uncertainty has been defined as a state of knowledge in which one or more alternatives result in a set of specific outcomes but where the probabilities of the outcomes are neither known nor meaningful.”
“Uncertainty is relatively subjective, there being insufficient past information, insufficient stability of the structure of variables to permit exact prediction.”
Meaning and Definitions of Derivatives
Meaning of Derivative
A derivative security is a financial contract whose value is derived from the value of something else, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.
Various Definitions of Derivatives
1. Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soyabean, cotton, coffee and what you have.
2. Thus, a 'derivative' is a financial instrument, or contract, between two parties that derived its value from some other underlying asset or underlying reference price, interest rate, or index. A derivative by itself does not constitute ownership, instead it is a promise to convey ownership. The Underlying
Securities for Derivatives are:
(a) Commodities (Castor seed, Grain, Coffee beans, Gur, Pepper, Potatoes)
(b) Precious Metals (Gold, Silver)
(c) Short-term Debt Securities (Treasury Bills)
(d) Interest Rate
(e) Common Shares/Stock
(f) Stock Index Value (NSE Nifty)
Characteristics of Derivatives:
1. Derivatives have the characteristic of Leverage or Gearing. With a small initial outlay of funds (a small percentage of the entire contract value) one can deal big volumes.
2. Pricing and trading in derivatives are complex and a thorough understanding of the price behaviour and product structure of the underlying is an essential pre-requisite before one can venture into dealing in these products.
3. Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments.
4. Derivatives have the characteristics of high leverage and of being complex in their pricing and trading mechanism.
5. Derivatives enable price discovery, improve the liquidity of the underlying asset, serve as effective hedge instruments and offer better ways of raising money.
Functions of Derivatives:
1. Transfer of risks-Derivatives shift the risk from the buyer of the derivative product to the seller and as such are very effective risk management tools.
2.Maintaining liquidity- Derivatives improve the liquidity of the underlying instrument.
3.Price Discovery: Derivatives perform an important economic function viz. price discovery. They provide better avenues for raising money. They contribute substantially to increasing the depth of the markets.
4.Check on Speculation-Derivatives help in hedging the risk against unfavourable price movements of assets with the help of future and forward contracts
5.Encourages young investors and entrepreneurs
6.Motivates and increases savings and investments
Types of Derivatives
Type 1: Forward Contracts
Forward contracts are the simplest form of derivatives and is nothing but an agreement to sell something at a future date. The price at which this transaction will take place is decided in the present.However, a forward contract takes place between two counterparties. This means that the exchange is not an intermediary to these transactions. Hence, there is an increase chance of counterparty credit risk.
Type 2: Futures Contracts
A futures contract is very similar to a forwards contract. The similarity lies in the fact that futures contracts also mandate the sale of commodity at a future data but at a price which is decided in the present.However, futures contracts are listed on the exchange. This means that the exchange is an intermediary. Hence, these contracts are of standard nature and the agreement cannot be modified in any way.
Type 3: Option Contracts
The third type of derivative the options contract, is asymmetrical. An options contract, binds one party whereas it lets the other party decide at a later date i.e. at the expiration of the option. So, one party has the obligation to buy or sell at a later date whereas the other party can make a choice.
There are two types of options i.e. call option and put option. Call option allows you the right but not the obligation to buy something at a later date at a given price whereas put option gives you the right but not the obligation to sell something at a later date at a given pre decided price.
Type 4: Swaps
Swaps are probably the most complicated derivatives in the market. Swaps enable the participants to exchange their streams of cash flows. The most common example is swapping a fixed interest rate for a floating one. Participants may decide to swap the interest rates or the underlying currency as well.
Swaps enable companies to avoid foreign exchange risks amongst other risks. Swap contracts are usually not traded on the exchange.
Participants in derivatives market
Participants can be divided into the following categories based on their trading motives:
- Hedgers: These are risk-averse traders in stock markets. They aim at derivative markets to secure their investment portfolio against the market risk and price movements. They do this by assuming an opposite position in the derivatives market. In this manner, they transfer the risk of loss to those others who are ready to take it. In return for the hedging available, they need to pay a premium to the risk-taker.
- Speculators: These are risk-takers of the derivative market. They want to embrace risk in order to earn profits. They have a completely opposite point of view as compared to the hedgers. This difference of opinion helps them to make huge profits if the bets turn correct.
- Margin traders: A margin refers to the minimum amount that you need to deposit with the broker to participate in the derivative market. It is used to reflect your losses and gains on a daily basis as per market movements. It enables to get leverage in derivative trades and maintain a large outstanding position.
- Arbitrageurs: These utilize the low-risk market imperfections to make profits. They simultaneously buy low-priced securities in one market and sell them at a higher price in another market. This can happen only when the same security is quoted at different prices in different markets.
1.Hedge Risks-Derivative trading lets you hedge your position in the cash market. For example, if you buy a positional stock in the cash market, you can buy a Put option in the derivative market. If the stock tumbles in the cash market, the value of your Put option will increase. Hence, your losses will be minimal or nil.
Factors contributing to the explosive growth of derivatives are price volatility, globalization of the markets, technological developments and advances in the financial theories.
1. Price Volatility
A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one’s own currency for a unit of another currency is called as an exchange rate.
2. Globalization of the Markets
Globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins
3. Technological Advances
A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price.
4. Advances in Financial Theories
Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets.
Recent Trends in derivative market India
1 FMC-SEBI merger - On 28 September 2015, the FMC was merged with the Securities and Exchange Board of India (SEBI) to make the regulation of commodity futures market strong. This is the first major case of two regulators being merged. It has restored confidence among market participants about regulatory oversight on commodities that is as strong as in equities.
2 Mutual Fund participation in Commodity Derivatives To include institutional investors into exchange traded commodity market SEBI has allowed the participation of Mutual Funds in commodity derivatives like gold, crude, copper, silver etc. Effective 2019 May 21, MFs can participate in gold derivatives only through Gold exchange traded funds launched by asset management companies (AMCs) and in other commodity derivatives through hybrid schemes, which currently invest in equity, debt and gold, SEBI said in a circular on the same date. “SEBI’s decision to amend SEBI (Custodian of Securities) Regulations, 1996 will allow small players to hedge their commodity risk through mutual funds. Until now, traders were allowed only through direct membership,” said Kishore Narne, Associate Director (commodities and currencies), Motilal Oswal Financial Services Ltd.
3. Reduction in penalty for abnormal trades On December 13, 2018 both BSE and NSE issued a circular on abnormal or non-genuine transactions. They asked the trading members to refrain from practices leading to tax evasion and such. They reduced the fine to 15%. "The exchange shall levy a penalty of 15% of the profit earned or loss incurred on the trading members for both profit and loss making abnormal or non-genuine transactions after following the due process
4. Physical settlement of Stock derivatives Prior to January 2019, in the futures and options market the settlement was either on a cash basis or physical.On the New Year’s Day of 2019, SEBI issued a framework for making physical settlement of stock derivatives mandatory. This was done in a phased manner. By October 2019, SEBI achieved the target of complete physical settlement of stock derivatives. This was carried out to curb excessive speculation and volatility in share prices.
5 Increased trading hours for commodity derivatives market. In December 2018, SEBI increased the trading time in the commodity derivatives market by an hour. The objective of the change is to deepen the commodity derivatives market as well as to enhance the participation of stakeholders, including farmer produce organisation and foreign entities.
6 Launching of MCXCCL The Multi Commodity Exchange of India Ltd (MCX) on 2018 August received the recognition from market regulator SEBI to launch operations of its wholly-owned subsidiary, Multi Commodity Exchange Clearing Corporation Ltd (MCXCCL). It is the first clearing corporation in the commodity derivatives market. The clearing corporation provides collateral management and risk management services, along with clearing and settlement of trades executed on the Exchange.
7 Reducing dependence on LME In 2013, Multi Commodity Exchange of India (MCX) signed a licensing agreement with the London Metal Exchange (LME), according to which MCX would use the current prevailing prices on the LME for settling future contracts. The exchange was paying high fees to LME & Chicago Mercantile Exchange for price discovery. Calendar 2019 got a very good start in which MCX has taken a step to modify optional delivery of zinc and aluminium to compulsory delivery mechanism. Now, both aluminium and zinc contracts have become ‘compulsorily deliverable instead of ‘both options’ (cash and delivery). Domestic price discovery is possible if delivery of goods is involved as it could promote local price pooling. This will in turn reduce the dependence on LME for price discovery up to a point where LME can be completely de-linked from India’s commodity markets.
8 India becomes largest derivative market by volume India’s National Stock Exchange has surpassed America’s CME Group Inc. to become the world’s largest derivatives bourse by volume. Mumbai-based NSE traded the most contracts in the world in 2019, the exchange said in a statement, citing data from the Futures Industry Association. Volume on the Indian exchange grew 58% to about 6 billion derivative contracts in 2019, surpassing CME’s 4.83 billion, according to FIA’s website.
9 AI & Derivatives Artificial Intelligence (AI) seems to have a finger in every pie these days. Already some of the big firms like Manulife (a Canadian financial service group), JP Morgan, Bank of America etc utilizes AI in different manner. Even for complex derivatives, artificial intelligence can certainly provide some great value, in terms of pricing, valuations, extracting information, etc. NSE is betting big on AI. The idea, is to enhance the efficacy of the capital markets, improve surveillance operations to prevent manipulation of its systems, and enable more efficient reporting to regulators. In coming years AI can be big game changer in the overall financial market.
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Syllabus of unit 1 of Derivatives and risk management
Unit 1: RISK MANAGEMENT (12hrs) Introduction, Risk and Uncertainty, Classification of Risks, Scope, Objectives, Process, Role of Risk Management in Business, Introduction to Derivatives, Evolution of Derivatives, Meaning & Definition, Characteristics, Functions, Types of Derivatives – Introduction, Meaning & Definition, Participants, Uses, Economic Benefits of Derivatives, Factor Contributing to the growth of Derivatives in India, recent trend in Derivatives.
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