Derivatives Understanding Risk

8/8/2019 Derivatives Understanding Risk

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Financial Derivatives

Understanding Risk in the Market

Instruments for Risk management



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Introduction

The Academic discipline of finance was developed inthe U.S during the forties, fifties and sixties withpioneering works by Nobel Laureates Tobin,Markowitz, Modigliani, Miller and others.

Subsequently, a whole range of ideas and modelswere developed in the theory of investments-Markowitz Model, Capital Asset Pricing Model and

Arbitrage Pricing theory are among the major works.Relying on such theories and models, trillions of

dollars are invested throughout the world.Derivatives were first devised for hedging risk, later

with the innovation of securitization, it hasemerge as a very important investment andspeculation instrument.



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Risk and risk mgmt.

Risk is defined as the uncertainty

surrounding the outcome of a future event

Risk management is the process by which

various risk exposures are identified,

measured and controlled.



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State of risk management



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What it is not?

´Man in white coat syndromeµ



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What it is?

´art of approximationsµ



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Interest in risk management is due to

volatility



1971

Collapse of Bretton woods EX rates became flexibleand volatile

1973 Oil price shocks Inflation

1987 Black Monday 1 trillion capital shaved

1989 Japanese stock marketdeflated

Nikkei declined from39,000 to 17,000 in 3 yrs

1994 Fed incraesed rates 6times consecutively

Bond market debacle

1997 Asian crisis Emerging markets

became pariahs2008 as a aftermath of subprime crisis Sensex fell from

21000 point to 8000 points despite no significant change infundamentals..

And the saga continues..

We live in a risky world



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Fed rates 1990-05



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LIBOR 2000-05

LIBOR: London Inter Bank Offer Rate



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NYMEX crude oil futures Jan 2004-05



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INR USD 1973-93



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INR- USD



N i f t y 2 0 0 3 - 0

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Reasons for volatility

Deregulation

Globalization



Rank the Financial Instrument according totheir corresponding risk..

Equity Share

Short Term Bond issued by Government (RBI).

Short term bond issued by Tata.

Long term bond issued by Government. (RBI) Long term bond issued by ICICI Bank.

Preference shares issued by BHEL.

Nifty Future.

Options on Reliance.

@Himanshu Joshi,JUIT (H.P)16



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Taxonomy of risks

Market risk

Credit risk

Liquidity risk

O

perational risk Legal risk

Interest rate risk



@Himanshu Joshi,JUIT (H.P)18

Market risk

the risk incurred in trading assets and liabilities

due to changes in interest rates, exchange

rates, and other asset prices

Directional risk ² risk of loss due to unfavorable

movement in the direction of u/l asset,

exchange rate, interest rate or index

Volatility risk²

risk of loss due to unfavorablemovement in volatility



Risk of Debt Securities

Interest Rate Risk: debt securities, which payfixed coupon rates, suffer a price decline wheninterest rates go up unexpectedly, because thestated coupon is inadequate to compensate for the

prevailing higher level of interest rates.

F

ixedIncome

Security

Prices

PrevailingInterest Rate

In the Market



Risk of Debt Securities

Likewise reinvestment of fixed contractualcoupons becomes risky when market interest ratedecline.

Re-investm

ent Risk

PrevailingInterest Rate

In the Market



Credit Risk

Treasury securities do not carry credit risk.However there are corporate bonds that carrysignificant amount of credit risk: that the issuermay be unable to service all or some of the

promised obligations due to financial distress,reorganization, workouts, or bankruptcy.



Liquidity Risk

Some debt securities may trade in illiquid markets(few dealers, wide bid-offer spreads, low depth,and so on).

Emerging market debt and some high yield debt

fall into this category. Liquidity refers to the ease with which a

reasonable size of a security can be transacted inthe market within a short notice, without adverse

price reaction.



Liquidity Risk

The seller or the buyer will face following:

1. High Transaction costs such as fees andcommissions,

2. Bid-offer spreads

3. Market impact costs, which refer to the possibilitythat following the placement of a buy (Sell) orderthe market makers may increase (Decrease) theprices at which they are willing to trade.



Contractual Risk

Debt securities may be callable by the issuer at theissuer·s option.

Holders of mortgage loans have the right to prepay theirold mortgages if they can refinance them at a cheaperrate.

This implies that prepayment should increase whenmortgage rates in market drop.

The lender will want to charge a higher interest rate toaccount for the fact that he or she is giving the borrowera valuation option to call away the loans when interest rate

fall in the market. This is ´call riskµ in the mortgages. Hence mortgages must trade at a yield higher than similar

non callable treasury debt securities.



Inflation Risk

Inflation risk is the risk that money obtained in the future will beworth less than when it is invested, which is almost always the case.

The real risk is how much this risk will be. On the other hand, it ispossible, in some cases, to take advantage of deflation that occurswhen interest rates rise.

A good example is when interest rates are rising, newly issued

fixed-income securities start to pay more, while prices of thingsthat generally require borrowing, such as real estate, startdeclining.

Thus, for instance, one could buy 4 week T-bills as a way to save fora house or for a down payment. As the T-bills expire, they can bere-invested at progressively higher rates (while rates are rising).

In the meantime, real estate prices are falling because it is

becoming more expensive to borrow the money to pay for it. So themoney earned on the T-bills becomes even more valuable than theinterest rate itself suggests when used to purchase real estate.



Event Risk

Some debt securities may be sensitive to events suchas hostile reorganizations or leveraged buyouts (LBOs).Such events can lead to a significant price loss.

In October 1988 RJR Nabisco was taken over through

an LBO. The resulting company took on heavy debt tofinance the takeover. As a result Moody·s rating forRJR Nabisco·s debt from A1 to B3.

The prices of RJR Nabisco dropped about 15%, and yield spread went from about 100 BPS above treasury

to 350 BPS above treasury. In corporate debt market this risk is called event risk.



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Operational risk

the risk of loss due to errors in processes andcontrols

Model risk ² risk of loss due to errors in thefinancial mathematics or assumptions underlyinga model used for valuation purposes



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Legal risks

Risk of loss due to legal events



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What to do with all these?

´ARTµ philosophy

² Accept the risk (e.g., self-insure)

²Remove the risk (divest, diversify)

² T ransfer the risk (hedging, insurance)



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Risk Management process

Risk Identification

Risk quantification

Risk monitoring and reporting

Derivatives Understanding Risk

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