The Derivatives

Various Risks Associated with Derivative Products

6/9/2017 By Rohan Byanjankar 1

Various types of risks associated with derivatives product

Derivatives

• Derivatives are the financial instruments whosevalue is derived from the underlying assets.

• It is called derivatives as its value is derived fromother assets called underlying asset.

• It is a contract that derives its value from changes inthe 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.

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Various types of risks associated with derivatives product

Examples of Derivatives

• Example 2:

• John (buyer) and Roman (seller) enters into a calloption 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 inprojects. Anju receives 10 percent interest perannum, while Manju receives 8 percent LIBOR plusvariable interest rates.

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Various types of risks associated with derivatives product

• Example 4:

• Anand (Seller) and Manoj (Buyer) enters intoforward contract to transact 10 Ropani of Land @Rs. 15 lakhs per Ropani after 3 months.

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Examples of Derivatives

Various types of risks associated with derivatives product

How there is risk in derivatives?

• The value of derivatives is derived from theunderlying securities; likewise, the risk inderivatives are also derived from thoseunderlying assets.

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Various types of risks 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

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Various types of risks associated with derivatives product

5. Model Risk

6. Legal Risk

7. Settlement Risk

8. Leverage Effect

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Risk associated with derivative products

Various types of risks associated with derivatives product

1. Counterparty Risk

• Risk exposed due to default or delinquency byone of the counterparties,

• If one of the parties of the contract defaults, thenthe counterparty default or credit risk arises.

• Example 5:

• John (buyer) and Roman (seller) enters into acall option contract… (See Slide 3)

• If Roman defaults (assuming that market pricehikes), then John suffers counterparty risk.

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Various types of risks associated with derivatives product

2. Market Risk

• Market risk refers to the possibility of losses dueto fluctuations in interest rates, price andexchange rates.

• Interest rate swap suffers interest rate risk,currency swap suffers exchange rate risk, andoption, forward, and futures suffer price risk.

• Example 6:

• Anju and Manju enters into interest rateswap… (See Slide 3). Anju suffers if interestrate falls.

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Various types of risks associated with derivatives product

• Example 7:

• John (buyer) and Roman (seller) enters into acall option … (See Slide 3)

• Roman suffers if price rises (↑) surpassingexercise price, while John losses premium ifmarket price (↓)is less than exercise price.

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2. Market Risk

Various types of risks associated with derivatives product

3. Liquidity Risk

• Liquidity risk is the risk exposed to derivativeinstrument holder either due to illiquidunderlying asset.

• Example 8:

• Anand (Seller) and Manoj (Buyer) enters intoforward contract… (See Slide 3)

• NRB directive not to grant loan for landpurchases after 3 months will make land illiquid.

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Various types of risks associated with derivatives product

4. Operational Risk

• Operational risk is the prospect of loss resultingfrom inadequate or failed procedures, systems orpolicies. Employee errors. Systems failures.Fraud or other criminal activity. Any event thatdisrupts business processes.

• Operational risk arises through: Industry events,regulatory development, new technology, androle of counterparty.

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Various types of risks associated with derivatives product

5. Model Risk

• Model Risk arises because of improper pricingof derivative securities, which is the resultant ofapplication of inappropriate model or incorrectinput.

• Example 9:

• Improper pricing of options is its example.

• Valuation of American Option using BlackScholes Model.

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Various types of risks associated with derivatives product

6. Legal Risk

• Legal risk arises due to failure in enforcing contract.

• Anand (Seller) and Manoj (Buyer) enters intoforward contract… (See Slide 3). However,Manoj is unable to purchase the land because ofmassive property loss due to earthquake.Forward contract turns to option… (legalfailure)

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Various types of risks associated with derivatives product

7. Settlement Risk

• Settlement risk is the risk that one party will failto deliver the terms of a contract with anotherparty at the time of settlement.

• It generally incurs in international trade.

• This occurs accidently, while both parties act ingood faith.

• This type of risk can lead to principal risk.

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Various types of risks associated with derivatives product

• A small change in price of underlying asset will cause huge profit or loss.

• It is basically seen in option.

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8. Leverage Effect

Various types of risks 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

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Various types of risks associated with derivatives product

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