Importance of derivatives in risk management

Importance of derivatives in risk management

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  Importance of Derivatives in RiskManagement
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  WHAT IS ADERIVATIVE ?  A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset
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  TYPES OF DERIVATIVES Forwards  Futures  Options  Swaps
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  FORWARD A forward contractis a contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed. The contract price is generally not available in public domain.
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  FUTURE A futures contractis an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike forward contracts, futures contracts are normally traded on an exchange.
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  OPTION • An Optioncontract is a contract between two parties whereby one party obtains the right but not the obligation to buy or sell a particular asset at a specified price on or before a specified date • Options can be traded in both OTC market and exchange traded markets.
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  TYPES OF OPTION •CALL OPTION: Call option gives the holder the right to buy the underlying asset by a certain date for a certain price. • PUT OPTION: Put option gives the holder the right to sell the underlying asset by a certain date for a certain price.
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  SWAP • A swapis a derivative contract made between two parties to exchange cash flows in the future. • Interest rate swaps and currency swaps are the most popular swap contracts, which are traded over the counters between financial institutions. These contracts are not traded on exchanges.
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  RISK MANAGEMENT Expected returnis the uncertain future return that an investor expects to get from his investment. Risk is the potential for variability in returns. Risk management is the human performance which incorporates identification of hazard, assessment of risk, improving plans to control it. Elements of Risk : ❶ Systematic Risk ❷ Unsystematic Risk  i.e. Total Risk = Systematic risk + Unsystematic risk
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  SYSTEMATIC RISK The variabilityin security returns caused by external factors such as economic, political and social systems is referred as Systematic risk(𝜷) 𝜷 = 𝜸im 𝝈i 𝝈m 𝝈2 m  𝜸im- Correlation coefficient between the returns of stock i and returns of the market index.  𝝈i-standard deviation of returns on stock i.  𝝈m-Standard deviation of the returns of the market index.  𝝈2 m-Variance of the market return.
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  Contd.. Systematic risk isdivided into three i. Interest rate risk: Type of systematic risk that particularly affects debt securities like bonds and debentures. E.g.: Bond having face value 1000Rs; coupon rate =10%; market interest rate=10% then the market price will be ( 100 10 × 100) = 1000rs if the market interest rate moves up to 12%,then market price will be ( 100 12 × 100) = 833.33rs
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  Contd.. ii. Market risk: -Typeof systematic risk that affects shares. -Market price may go up & down iii. Purchasing power risk: -It refers to the variation in investor return caused by inflation -Inflation Purchasing power of money -Two important sources of inflation are rising costs of production & excess demand for goods and services in relation to their supply
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  UNSYSTEMATIC RISK When variabilityof returns occurs because of internal factors such as raw material scarcity, labour strike, management inefficiency is known as Unsystematic Risk. It is divided into two i. Business Risk: It is a function of the operating conditions faced by a company and is the variability in operating income caused by the operating conditions of the company. ii. Financial Risk: It is the risk originates due to the inclusion of debt capital in the capital structure Debt capital Financial risk
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  FUNCTIONS OF FINANCIALDERIVATIVES • Helps in control, avoid, shift and manage efficiently different types of risks through various strategies like hedging, arbitraging, spreading. • Enables to discover or form suitable or correct or true equilibrium prices in the market. • Helps in enhancing liquidity and reduce transaction costs in the markets.
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  CONT… • Helps investors,traders, and managers to devise strategies so that asset allocation makes easier. • Smoothen out price fluctuations and squeeze the price spread, integrate price structure at different points of time. • Helps in encouraging the competitive trading in the markets different risk taking by speculators, hedgers and encourages young investors and professionals.
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  THANK YOU HAPPY TRADING…….