Financial Derivatives & Risk Management

8/14/2019 Financial Derivatives & Risk Management

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Financial Derivatives &

Risk Management



Objectives: Understand the risk, its elements and

uncertainty

To understand nature of risk To study different interpretation of risks

To know about Risk management process &methods

To understand the overall objectives of riskmanagement is to minimize the cost of risk.



Is

Risk is symbol of Danger

Or

Symbol of Opportunity ?



It is

symbol of both

Danger & Opportunity



The only one thing is certain about

Stock Market is…………..



………….. Uncertainty !



“Playing with F & O is injurious to Wealth”

“ You will burn your money in Derivatives, if not done ina systematic way”

But at the same time ‘It is Money Vending Machine’ .

Learn to make money through……

Trade in Derivatives Systematically & Strategically



Risk ManagementMeaning:

“Risk can be defined as the possibility of loss arising

because of uncertainty of outcome of particular transaction”.

“Risk refers to variability of the actual returns

from the expected returns in terms of cash flows”.

“Risk management seeks to mitigate variabilityand expected losses and increase welfare”.



Elements of Certainty and RiskCertainty: Is the situation where it is

known what will happen and the

happening of an event carries a100 percent probability.

Risk: Is the situation when there are

a number of specific, probableoutcomes, but it is not certain as towhich one of them will actually

happen.



Elements of Uncertainty and

Risk….

Uncertainty: Is where even theprobable outcomes are unknown.

It reflects a total lack of knowledgeof what may happen.

The Webster's Dictionary says that ‘

Risk’ is the possibility of somethingunpleasant happening or thechance of encountering loss or

harm.



Nature of risk: Important nature of risk is uncertainty.

One cannot predict risk when it will

occur. Its period of occurrence is notknown.

It relates to theory of probability and it

standards more on guess work ratherthan actual.

Risk exists in any activities when the

decision maker is in a position to assign

probabilities to various outcomes.



Different Interpretation of

Risk

Risk can be divided into;1. Pure Risk (PR) and Speculative Risk

(SR): PR are those in which the outcome tends tobe a loss with no possibility of gain.Ex: the risk of fire in a godown

SR are those in which there is a possibilityof gain or loss.Ex: Secondary market

While PR can be insured

SR cannot be insured



Pure risk encompasses risk of loss from (a)

damage to and theft or expropriation of

business assets, (b) legal liability forinjuries to customers and other parties, (c)

workplace injuries to employees, and (d)

obligations assumed by businesses under

employee benefit plans.

Pure risk frequently is managed in part by

the purchase of insurance to finance losses

and reduce risk.



2. Acceptable and Non-acceptable Risk:

While risks are unavoidable in any business the

potential loss may be so minimal. Ex: a loss of

few stationeries in a month is acceptable.

Certain risks are major and those are known as

non-acceptable. Ex. A major financial loss of Rs.50 crore is non-acceptable risk.



3. Static Risks and Dynamic Risks:

Risks that do not depend on various

scenarios like pure risks are a typeof static risks

Some risks depend on changes in the

economical, political, social andother scenarios like speculativerisks are a type of dynamic risks.



Risk Management

Risk management is a systematic approach

in identifying, analyzing and controlling

areas or events with the potentials for

causing unwanted change. It is through risk

management that risks to any specific

programmed are assessed and

systematically managed to reduce risk to an

acceptable level.



Types of Risk (Business &

Individuals)

1. Business Risk : Is concerned withpossible reductions in business value

from any source. The business valueinclude Price risk, Credit risk and Purerisk.

2. Personal Risk: The risks faced byindividuals and families viz., earningsrisk, medical expense risk, liabilityrisk, physical asset risk, financial

asset risk.



Risk Management Process Risk Mgmt. process involves:

1. Identify all significant risks.

2. Evaluate all potential frequency and

severity of losses.3. Develop and select methods for

managing risk.

4. Implement the risk management

methods chosen.5. Monitor the performance and suitability

of the risk management methods andstrategies on an ongoing basis.



Risk Management Methods:

Major risk management methods include:

1. Loss control

2. Loss financing3. Internal risk reduction

Loss control & Internal risk reduction arecommonly involve decisions to investresources to reduce expected losses.

Loss financing decisions refer to decisionsabout how to pay for losses if they do

occur.



RM methods contd…..

Loss Control Internal risk reduction

Loss Financing

Increasedprecautions

Retention andself-insurance

Insurance

Hedging

Other

contractual risk transfers

DiversificationReduced levelof riskyactivity



Objectives

The overall objectives of risk management isto minimize the cost of risk.

Risk mgmt. seeks to mitigate variability andexpected losses and increase welfare.

Cost of risk:

Components of the cost of risk include;

1. the expected cost of loss,

2. the cost of loss control,

3. the cost of loss financing,



Cost of risk contd…..

4. the cost internal risk reduction, and

5. the cost of any residual uncertainty that

remains after loss control, loss financing,and internal risk reduction methods havebeen implemented.

In the context of business risk

management, maximizing firm value isequivalent to minimizing the cost of risk.



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Financial Derivatives & Risk Management

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