1. Derivatives and Risk Management
Chapter 1: Introduction
- Mr. Amol Padhye
September 23, 2012

2. Definition
What is the definition of Derivatives ?
In finance, a security whose price is dependent on or derived from one or more
underlying assets.
The derivative itself is merely a contract between two or more parties, with a value
determined by fluctuations in the underlying asset, which could be stocks, bonds,
commodities, currencies, interest rates, and market indexes.
Most derivatives are characterized by high leverage.
What do you mean by Risk Management ?
Risk management is the identification, assessment and prioritization of risks
followed by coordinated and economical application of resources to minimize,
monitor, and control the probability and/or impact of unfortunate events or to
maximize the realization of opportunities.
The strategies to manage risk include transferring the risk to another party,
avoiding the risk, reducing the negative effect of the risk, and accepting some or all
of the consequences of a particular risk.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

3. Derivatives: Utility
Derivatives are used by investors to:
Provide leverage or gearing, such that a small movement in the underlying value can cause a
large difference in the value of the derivative
Speculate and to make a profit if the value of the underlying asset moves the way they expect
(e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)
Hedge or mitigate risk in the underlying, by entering into a derivative contract whose value
moves in the opposite direction to their underlying position and cancels part or all of it out
Obtain exposure to underlying where it is not possible to trade in the underlying
Create optionability where the value of the derivative is linked to a specific condition or event
(e.g., the underlying reaching a specific price level)
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

4. Hedging v/s Speculation
Hedging:
Hedging is a technique that attempts to reduce risk. In this respect, derivatives can be
considered a form of insurance.
Portfolio managers, individual investors and corporations use hedging techniques to reduce their
exposure to various risks.
For example, if you buy house insurance, you are hedging yourself against fires, break-ins or
other unforeseen disasters.
In financial markets, however, hedging becomes more complicated than simply paying an
insurance company a fee every year. Hedging against investment risk means strategically using
instruments in the market to offset the risk of any adverse price movements. In other words,
investors hedge one investment by making another.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

5. Hedging v/s Speculation
Speculation
Derivatives can be used to acquire risk, rather than to insure or hedge against risk.
Enter into a derivative contract to speculate on the value of the underlying asset, betting that
the other party will be wrong about the future value of the underlying asset.
Speculators will want to be able to buy an asset in the future at a low price according to a
derivative contract when the future market price is high, or to sell an asset in the future at a high
price according to a derivative contract when the future market price is low.
Speculation should not be considered purely a form of gambling, as speculators do make
informed decision before choosing to acquire the additional risks.
Speculation cannot be categorized as a traditional investment because the acquired risk is
higher than average.
For example: Land speculation occurs when investors pay higher prices for land they hope will
be developed or converted to a more intensive use in the near future.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

6. Are Derivatives Bad ?
Warren Buffet defined Derivatives as “financial weapons of mass
destruction”
In light of recent Credit Crisis, whether the Derivatives are bad ?
NO
Derivatives by itself can not be bad / dangerous.
It is the user of the instrument and its intentions define the quality.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

7. Risk Management – Market & Liquidity Risk
Market & Liquidity Risk, Counterparty Risk
Market risk is defined as the risk of losses in on-balance sheet and off balance sheet positions
arising from movements in market prices
Liquidity risk is the risk that the organisation cannot meet its payment obligations as and when
they fall due.
Following broad category of risks form part of market risks:
Interest Rate Risk
Foreign Exchange Risk
Commodity Risk
Equity Risk
Counterparty Risk concept is gaining momentum. It is a bit different from Credit Risk but tries to
focus on combined market & credit risk aspects.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

8. Risk Management – Credit Risk
Credit Risk
Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or
interest (coupon) or both)
Four Cs of Credit Analysis
Character
Refers to management’s integrity and its commitment to repay the load or any other line of credit.
Management’s ability to react appropriately to unexpected events.
Covenant
Terms and conditions the borrowing and lending parties have agreed as part of bond issue.
Affirmative covenants require debtor to take certain actions viz. pay interest etc.
Negative covenants prohibit the borrower from taking certain actions viz. maintaining certain ratios,
limitations on taking additional debt etc.
Collateral
The assets offered as security for the debt as other assets controlled by issuer.
Capacity to Pay
Refers to borrower’s ability to generate cash flows or liquidate short term assets to repay its debt
obligations.
Firms liquidity position is key determining factor in its capacity to pay.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

9. Risk Management – Operational Risk
Operational Risk
Operational risk is the risk of incurring an economic loss due to inadequate or failed internal
processes, or due to external events, whether these events are deliberate, accidental or natural
occurrences. The management of operational risk is underpinned by an analysis of the cause -
event - effect chain.
An operational risk is a risk arising from execution of a company's business functions.
Operational risk encompasses legal risk, tax risk, information system risk and compliance risks.
Common cases of Operational Risks:
Settlement Risk
Delay in sending / receiving deal confirmations
Overdue reconciliation items
Shortage of head count etc.
System failure
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

10. Risk Management – Other Risk Categories
Break-Even / Business Risk:
Break-even risk is the risk of negative operating income (excluding impact of other risks like
market risk or operational risk) due to the inability to match costs to revenues. This situation may
result from changes of the business environment and lack of flexibility in the cost structure that
would let adjust costs in due course.
Reputation Risk
Reputation risk is the risk of damaging the trust of the customers, counterparties, suppliers,
employees, shareholders, regulators and any other stakeholders whose trust is an essential
condition for the Bank to carry out its day-to-day operations.
Strategic risk
Strategic risk is the risk of market share price fall because of the Bank’s strategic choices.
Country / Sovereign Risk
Risk arising from operating in specific country depending on fiscal, monetary, tax, legal
regulations.
Derivatives and Risk Management - Mr. Amol Padhye ‹#›

11. Typical Derivatives & Risk Management Products
Foreign Exchange Products Interest Rate Products
Fx Spot Interest Rate Swaps
Fx Forward Cross Currency Swaps
Fx Future Swaption
Fx Swap Forward Rate Agreement
Fx Options Interest Rate Options
Equity Products Credit Products
Cash Equity Credit Default Swap
Equity Futures Credit Linked Notes
Equity Options Collateralised Debt obligation
Money Market Product Fixed Income Products
Call Money Sovereign Bonds
REPO & Reverse REPO Treasury Bills
Liquidity Adjustment Facility Corporate Bonds
CBLO
Certificate of Deposits Exotic Products
Commercial Papers Any combination of one or more of the all
Non convertible Debentures above products
Derivatives and Risk Management - Mr. Amol Padhye ‹#›