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Risk Associated with Derivative Markets
The document discusses various risks associated with derivative products, which are financial instruments whose value is derived from underlying assets. Key risks include counterparty risk, market risk, liquidity risk, operational risk, model risk, legal risk, settlement risk, and leverage effect; each risk is exemplified to illustrate potential implications. Mitigation strategies for these risks are also outlined, such as utilizing credit derivatives for counterparty risk and maintaining robust systems to address operational risk.
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Risk Associated with Derivative Markets
- 1. The Derivatives Various RisksAssociated with Derivative Products 1/17/2019 By Rohan Byanjankar 1
- 2. Various types ofrisks associated with derivatives product Derivatives • Derivatives are the financial instruments whose value is derived from the underlying assets. • It is called derivatives as its value is derived from other assets called underlying asset. • It is a contract that derives its value from changes in the price of the underlying asset. Example 1: The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold. 1/17/2019 By Rohan Byanjankar 2
- 3. Various types ofrisks associated with derivatives product Examples of Derivatives • Example 2: • John (buyer) and Roman (seller) enters into a call option contract to trade 100 shares of HBL @ Rs. 1400 each; option premium of Rs. 20 per share. • Example 3: • Anju and Manju enters into interest rate swap. Anju and Manju have invested Rs. 10000 in projects. Anju receives 10 percent interest per annum, while Manju receives 8 percent LIBOR plus variable interest rates. 1/17/2019 By Rohan Byanjankar 3
- 4. Various types ofrisks associated with derivatives product • Example 4: • Anand (Seller) and Manoj (Buyer) enters into forward contract to transact 10 Ropani of Land @ Rs. 15 lakhs per Ropani after 3 months. 1/17/2019 By Rohan Byanjankar 4 Examples of Derivatives
- 5. Various types ofrisks associated with derivatives product How there is risk in derivatives? • The value of derivatives is derived from the underlying securities; likewise, the risk in derivatives are also derived from those underlying assets. 1/17/2019 By Rohan Byanjankar 5
- 6. Various types ofrisks associated with derivatives product Risk associated with derivative products 1. Counterparty Risk 2. Market Risk a) Interest Rate Risk b) Price Risk c) Foreign Exchange Risk 3. Liquidity Risk 4. Operational Risk 1/17/2019 By Rohan Byanjankar 6
- 7. Various types ofrisks associated with derivatives product 5. Model Risk 6. Legal Risk 7. Settlement Risk 8. Leverage Effect 1/17/2019 By Rohan Byanjankar 7 Risk associated with derivative products
- 8. Various types ofrisks associated with derivatives product 1. Counterparty Risk • Risk exposed due to default or delinquency by one of the counterparties, • If one of the parties of the contract defaults, then the counterparty default or credit risk arises. • Example 5: • John (buyer) and Roman (seller) enters into a call option contract… (See Slide 3) • If Roman defaults (assuming that market price hikes), then John suffers counterparty risk. 1/17/2019 By Rohan Byanjankar 8
- 9. Various types ofrisks associated with derivatives product 2. Market Risk • Market risk refers to the possibility of losses due to fluctuations in interest rates, price and exchange rates. • Interest rate swap suffers interest rate risk, currency swap suffers exchange rate risk, and option, forward, and futures suffer price risk. • Example 6: • Anju and Manju enters into interest rate swap… (See Slide 3). Anju suffers if interest rate falls. 1/17/2019 By Rohan Byanjankar 9
- 10. Various types ofrisks associated with derivatives product • Example 7: • John (buyer) and Roman (seller) enters into a call option … (See Slide 3) • Roman suffers if price rises (↑) surpassing exercise price, while John losses premium if market price (↓)is less than exercise price. 1/17/2019 By Rohan Byanjankar 10 2. Market Risk
- 11. Various types ofrisks associated with derivatives product 3. Liquidity Risk • Liquidity risk is the risk exposed to derivative instrument holder either due to illiquid underlying asset. • Example 8: • Anand (Seller) and Manoj (Buyer) enters into forward contract… (See Slide 3) • NRB directive not to grant loan for land purchases after 3 months will make land illiquid. 1/17/2019 By Rohan Byanjankar 11
- 12. Various types ofrisks associated with derivatives product 4. Operational Risk • Operational risk is the prospect of loss resulting from inadequate or failed procedures, systems or policies. Employee errors. Systems failures. Fraud or other criminal activity. Any event that disrupts business processes. • Operational risk arises through: Industry events, regulatory development, new technology, and role of counterparty. 1/17/2019 By Rohan Byanjankar 12
- 13. Various types ofrisks associated with derivatives product 5. Model Risk • Model Risk arises because of improper pricing of derivative securities, which is the resultant of application of inappropriate model or incorrect input. • Example 9: • Improper pricing of options is its example. • Valuation of American Option using Black Scholes Model. 1/17/2019 By Rohan Byanjankar 13
- 14. Various types ofrisks associated with derivatives product 6. Legal Risk • Legal risk arises due to failure in enforcing contract. • Anand (Seller) and Manoj (Buyer) enters into forward contract… (See Slide 3). However, Manoj is unable to purchase the land because of massive property loss due to earthquake. Forward contract turns to option… (legal failure) 1/17/2019 By Rohan Byanjankar 14
- 15. Various types ofrisks associated with derivatives product 7. Settlement Risk • Settlement risk is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. • It generally incurs in international trade. • This occurs accidently, while both parties act in good faith. • This type of risk can lead to principal risk. 1/17/2019 By Rohan Byanjankar 15
- 16. Various types ofrisks associated with derivatives product • A small change in price of underlying asset will cause huge profit or loss. • It is basically seen in option. 1/17/2019 By Rohan Byanjankar 16 8. Leverage Effect
- 17. Various types ofrisks associated with derivatives product Type of risk and mitigating measures Types of Risk Mitigating Measures Counterparty risk Credit derivatives, credit default swaps Liquidity Risk Portfolio creation Operational Risk System maintenance Market Risk Value at risk, Delta hedging Legal Risk Regulatory legal framework 1/17/2019 By Rohan Byanjankar 17
- 18. Various types ofrisks associated with derivatives product ANY QUERIES ??? THANK YOU !!! 1/17/2019 By Rohan Byanjankar 18