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An Introduction

By RAJIV SRIVASTAVA

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RISK Specifically defined Risk can be defined as deviations of the actual results

from expected.

Risk can be classified two ways 1) risk of smalllosses with frequent occurrences and 2) risk of largelosses with infrequent occurrences.

The impact or magnitude of risk is normally

estimated from following two factors1. The probability of an adverse event happening, and

2. In case the event occurs the magnitude of the loss it cancause.

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CLASSIFICATION OF RISKPROJECTRISK FINANCIAL RISK

y Operational

y Regulatoryy Political

y Liquidity

y Human Resource

Can only be managed byprecautions in appraisal

Event specific risk aremanaged by insurance

y Price Risk

y

Currency Risky Quantity Risk

y Interest Rate Risk

y Credit Risk

y Portfolio Risk

y Default Risk

Mostly managed by financialtools such as diversificationand through derivatives

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CLASSIFICATION OF RISKEVENTRISK BUSINESS RISK

y Risk of large losses with small

probability such asearthquake, tsunami, riots,terrorism etc.

y May affect large number offirms/individuals.

Can be managed by insuranceif such policies are available

y Risk of small losses with large

probability such as price risk,exchange rate risk, interestrate risks specific to aparticular firm

y May affect large number of

firms/individuals.Can be managed byderivatives

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MANAGING RISK The ways to manage risk include attempt to control

potential damage, diffuse, diversify and transfer risk

to those willing to accept it. One can manage the risk bytransferring it to

another party who is willing to assume risk.

Insurance company does not do anything to contain

the risk per se but assumes risk on your behalf. Management of risk through derivatives is

commonly referred as hedging which enablesoffsetting of risk emanating from a situation.

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STRATEGICAND TACTICAL RISK

MANAGEMENTy The business risks of

1. price,

2. exchange rate, and3. interest rate as also the credit risk

can be managed through derivatives.

y Management of risk through derivatives is tactical asdistinct from strategic management.

y Strategic management is costly, mostly irreversible, timeconsuming and requires several opinions.

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DERIVATIVESy Derivatives are products that derive their value from

some other asset called underlying asset but in other

aspects they may remain distinctly different from andindependent of the underlying asset.

y Management of risk through derivatives is

1. quick,

2. economical,3. reversible, and

4. mostly provides protection in the short term.

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WHYMARKET FOR DERIVATIVESy If the prices of derivatives are linked to the physical market

then why have derivatives as separate instrument?

y Enables take separate and independent and oppositepositions in two different markets.

y If prices move in tandem opposite positions in two marketsit makes hedging feasible.

Spot/Physical Market erivativesMarket

Price from Spot Market

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erivatives

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TYPES F E I ATI ESyVariety of derivatives are available both as standard

product and tailor-made, to suit various applications.

y Four broad and basic types of instruments are:

y Forwards

y Futures

y Options, and

y Swaps,

y Combinations of derivatives are also available such asoptions on futures, swaptions etc for more complexapplications.

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TYES OF DERIV

ATIVES

Based on the underlying asset Based on how traded

The underlying asset can be

y

CommoditiesFinancial

y Currencies

y Shares/Indices

y Interest Rates

y CreditOthers

y Weather

y Energy

Derivatives can be traded

either on the exchange orO

TCyOver-the-counter (OTC)

y Forwards,

y Options,

y Swaps

yExchange Tradedy Futures,

y Options

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PARTICIPANTS IN DERIVATIVE

MARKETSHedgers: are those who use derivatives for hedging i.e.

reduce or eliminate risk.

Speculators: are those take positions in derivatives toincrease returns by assuming increased risk. Theyprovide much needed liquidity to markets.

Arbitrageurs: are those who exploit mispricing in two

different markets; They assume riskless andprofitable positions unlike speculators.

All 3 participants are essential for efficient functioning.

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hedgey In finance, a hedge is a position established in one

market in an attempt to offset exposure to price

changes or fluctuations in some opposite position withthe goal of minimizing one's exposure to unwantedrisk. There are many specific financial vehicles toaccomplish this, including insurance policies, forwardcontracts, swaps, options, many types ofover-the-counter and derivative products, and perhaps mostpopularly, futures contracts.

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FU CTI S F E I ATI ES3 major functions of derivatives are:

y Enable price discoverybecause two independentmarkets are available for the same asset. It increasesparticipation making markets deep. If derivatives areexchange traded then transparent prices are available

worldwide.

y Facilitate transfer of risk from those trying to avoidto those prepared to assume risk

y Provide leverage to attract speculators to participateand increase market depth enabling fair price.

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C ITICISM F E I ATI ESy Increased volatility: Though used for efficient pricediscovery, derivatives when used as a speculative productcan make increase volatility in prices.

y Increased bankruptcies: Derivatives being leveragedproducts have caused disproportionate positions leadingto several disasters and bankruptcies.

y Increased burden of regulations: Most derivatives hidemore than they reveal, liabilities being contingent innature. For financial discipline and better disclosures newrules have to be devised.

y Double-edged sword: If used judiciously it provides riskmitigation but if used injudiciously it magnifies risk.

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Rajiv Srivastavarajiv1234@hotmail.com