Derivatives and Risk Management1 1 2 Asato ma sat gamaya, tamaso ma jyotir gamaya, mrityo ma amritam gamaya Lead me from the superficial to the worthy, from darkness to light and from stagnation to zestful living Brahadaranyaka Upanishad (1,3,28) Derivatives and Risk Management3 3 4 Why do things go wrong ! Derivatives and Risk Management5 Why Disasters ? Unexpected Events Bad Maintenance Driver Error There are risks and costs to action. But they are far less than the long range risks and costs of comfortable inaction. -John F. Kennedy Global trends The rising importance of risk management In financial institutions More complex markets Global markets Greater product Complexity New businesses (e-banking, merchant banking,) Increasing competition New players Regulatory imbalances The change In the Distant Past... Institutions disaggregated their risks, and treated each one separately. However, today this approach is limited due to increasing Linkages between markets Importance of calculating portfolio effects, e.g issuer and counterparty risks, credit spread equity risks, etc. In the future... The leading institutions will be distinguished by their intelligent management of risk. Risk is multidimensional Market Risk : Equity; Interest Rate; Currency; Commodity Credit Risk Operational Risk Reputational Risk Business and Strategic Risks Derivatives and Risk Management11 Risk Management Derivatives and Risk Management12 What is Risk? Exposure to Uncertainty. Two components of Risk : Uncertainty Exposure to that Uncertainty Financial Risk is exposure to financial uncertainty RISK MANAGEMENT is Planned Method of dealing with UNCERTAINTIES to estimate Expected and Unexpected Losses Derivatives and Risk Management13 Risk Management Process Establish the context Plan Map out Define framework Develop an analysis Derivatives and Risk Management14 Risk Management Process Identify Source Analysis Problem Analysis Objectives-based / Scenario-based/ Taxonomy-based Risk Identification Risk Checklist Risk Chart Derivatives and Risk Management15 Risk Management Process Assess Rate of occurrence multiplied by the impact of the event equals risk Later research has shown that the financial benefits of risk management are less dependent on the formula used but are more dependent on the frequency and how risk assessment is performed.risk assessment Derivatives and Risk Management16 Risk Management Process Potential Risk Treatments (4 Ts) Tolerate (aka retention) Treat (aka mitigation) Terminate (aka elimination) Transfer (aka buying insurance) Derivatives and Risk Management17 Risk Management Process Risk Management Strategy Risk avoidance Risk reduction Risk retention Risk transfer Derivatives and Risk Management18 Risk Management Process Create the plan Implement Review and evaluate the plan Derivatives and Risk Management19 Financial Crisis Derivatives and Risk Management20 Truth and Lies about the Financial Crisis Hedge Funds are in part responsible for the crisis due to massive speculation: FALSE The Financial Crisis was a consequence of Excessive Traders' Bonuses: FALSE Rating Agencies Are to Blamed for the Subprime Crisis: TRUE Derivatives and Risk Management21 Subprime Crisis Derivatives and Risk Management22 Derivatives and Risk Management23 Derivatives and Risk Management24 Derivatives and Risk Management25 Too much Risk led to the Subprime Crisis? The issue with the subprime crisis was that no one was fully aware of where lied the risks, not that there was too much risk.... the difference is important. Derivatives and Risk Management26 Complex derivatives products led to the Financial Crisis: PARTLY FALSE Derivatives and Risk Management27 Sustainable Risk Management Do NOT Rely on Historical Data Focus on Narrow Measures Overlook Knowable Risks Overlook Concealed Risks Fail to Communicate Not manage in Real time Derivatives and Risk Management28 Sustainable Risk Management Do Build scenarios and design strategies for surviving them Have Effective Risk Reporting System Develop a Risk Culture that accepts and understand the limitations involved Ensure involvement of EVERY STAKEHOLDER in Risk Management Derivatives and Risk Management29 Derivatives Derivatives and Risk Management30 Introduction There is no universally satisfactory answer to the question of what a derivative is Often when a market participant suffers a large newsworthy loss, the term derivatives is used almost as if it were an explanation anything that results in a large loss dreaded D word WMD Derivatives and Risk Management31 Introduction (contd) Futures and options markets are very useful, perhaps even essential, parts of the financial system Futures and options markets have a long history of being misunderstood Derivatives and Risk Management32 Categories of Derivatives Futures Listed, OTC futures Forward contracts Options Calls Puts Swaps Interest rate swap Foreign currency swap Derivatives Derivatives and Risk Management33 Options An option is the right to either buy or sell something at a set price, within a set period of time The right to buy is a call option The right to sell is a put option You can exercise an option if you wish, but you do not have to do so Derivatives and Risk Management34 Futures Contracts Futures contracts involve a promise to exchange a product for cash by a set delivery date Futures contracts deal with transactions that will be made in the future Derivatives and Risk Management35 Futures Contracts (contd) Futures contracts are different from options in that: The buyer of an option can abandon the option if he or she wishes The buyer of a futures contract cannot abandon the contract Derivatives and Risk Management36 Futures Contracts (contd) A futures contract involves a process known as marking to market Money actually moves between accounts each day as prices move up and down A forward contract is functionally similar to a futures contract, however: There is no marking to market Forward contracts are not marketable Derivatives and Risk Management37 Swaps Introduction Interest rate swap Foreign currency swap Derivatives and Risk Management38 Introduction Swaps are arrangements in which one party trades something with another party The swap market is very large, with trillions of dollars outstanding Derivatives and Risk Management39 Interest Rate Swap In an interest rate swap, one firm pays a fixed interest rate on a sum of money and receives from some other firm a floating interest rate on the same sum Popular with corporate treasurers as risk management tools and as a convenient means of lowering corporate borrowing costs Derivatives and Risk Management40 Foreign Currency Swap In a foreign currency swap, two firms initially trade one currency for another Subsequently, the two firms exchange interest payments, one based on a foreign interest rate and the other based on a U.S. interest rate Finally, the two firms re-exchange the two currencies Derivatives and Risk Management41 Product Characteristics Both options and futures contracts exist on a wide variety of assets Options trade on individual stocks, on market indexes, on metals, interest rates, or on futures contracts Futures contracts trade on products such as wheat, gold, oil, foreign currency, treasury bonds, and stock market indexes Derivatives and Risk Management42 Product Characteristics (contd) The underlying asset is that which you have the right to buy or sell (with options) or the obligation to buy or deliver (with futures) Listed derivatives trade on an organized exchange such as the NSE or MCX or BSE Derivatives and Risk Management43 Product Characteristics (contd) OTC derivatives are customized products that trade off the exchange and are individually negotiated between two parties Options are securities and are regulated by the Securities and Exchange Board Of India (SEBI) Futures contracts are regulated by the Futures Trading Commission (FTC) Derivatives and Risk Management44 Participants in Derivatives Hedging Speculation Arbitrage Derivatives and Risk Management45 Hedging If someone bears an economic risk and uses the futures market to reduce that risk, the person is a hedger Hedging is a prudent business practice and a prudent manager has a legal duty to understand and use the futures market hedging mechanism Derivatives and Risk Management46 Speculation A person or firm who accepts the risk the hedger does not want to take is a speculator Speculators believe the potential return outweighs the risk The primary purpose of derivatives markets is not speculation. Rather, they permit the transfer of risk between market participants as they desire Derivatives and Risk Management47 Hedgers and Speculators HedgersSpeculators Risk Transfer Derivatives and Risk Management48 Arbitrage Arbitrage is the existence of a riskless profit Arbitrage opportunities are quickly exploited and eliminated Derivatives and Risk Management49 Arbitrage (contd) Persons actively engaged in seeking out minor pricing discrepancies are called arbitrageurs Arbitrageurs keep prices in the marketplace efficient An efficient market is one in which securities are priced in accordance with their perceived level of risk and their potential return Derivatives and Risk Management50 Uses of Derivatives Risk management Income generation Financial engineering Derivatives and Risk Management51 Risk Management The hedgers primary motivation is risk management Banks appears to have effectively used such instruments to shift a significant part of the risk from their corporate loan portfolios Alan Greenspan, 2002 Derivatives and Risk Management52 Risk Management (contd) Someone who is bullish believes prices are going to rise Someone who is bearish believes prices are going to fall We can tailor our risk exposure to any points we wish along a bullish/bearish continuum Derivatives and Risk Management53 Risk Management (contd) FALLING PRICES FLAT MARKETRISING PRICES EXPECTED EXPECTED EXPECTED BEARISH NEUTRAL BULLISH Increasing bearishnessIncreasing bullishness Derivatives and Risk Management54 Income Generation Writing a covered call is a way to generate income Involves giving someone the right to purchase your stock at a set price in exchange for an up-front fee (the option premium) that is yours to keep no matter what happens Writing calls is especially popular during a flat period in the market or when prices are trending downward Derivatives and Risk Management55 Financial Engineering Financial engineering refers to the practice of using derivatives as building blocks in the creation of some specialized product Financial engineers: Select from a wide array of puts, calls futures, and other derivatives Know that derivatives are neutral products (neither inherently risky nor safe) Derivatives and Risk Management56 Effective Study of Derivatives The study of derivatives involves a vocabulary that essentially becomes a new language Implied volatility Delta hedging Short straddle Near-the-money Gamma neutrality Etc. Derivatives and Risk Management57 Effective Study of Derivatives (contd) All financial institutions can make some productive use of derivative assets Investment houses Asset-liability managers at banks Bank trust officers Endowment fund managers Mortgage officers Pension fund managers Etc. Derivatives and Risk Management58 Text Books Options, Futures and other Derivatives : Hull (Pearson) Fundamentals of Financial Derivatives : Parasuraman (Wiley India) Futures and Options : Sridhar (Shroff Pub.) Derivatives-An Introduction : Strong (Thomson) Derivatives and Risk Management59 Glossary American Option: An option that can be exercised at any time during its life. Asian Option: An option with a payoff dependent on the average price of the underlying asset during a specified period. At-the-Money-Option: An option in which the strike price equals the price of the underlying asset. Average Strike Option: An option that provides a payoff dependent on the difference between the final asset price and the average asset price. Barrier Option: An option whose payoff depends on whether the path of the underlying asset has reached a barrier (I.e. A certain predetermined level). Basket option: An option that provides a payoff dependent on the value of a portfolio of assets. Bear Spread: A Short position in a put option with strike K1 combined with a long position in a put option with strike price K2, where K1 > K2. Derivatives and Risk Management60 Glossary Bermudan option: An option that can be exercised on specified dates during its life. Binary Option: Option with a discontinuous payoff; for example, a cash or nothing option or an asset-or-nothing option. Bull Spread: A long position in a call option with strike K1 combined with a short position in a call option with strike price K2, where K1 < K2. Delta Hedging: A hedging scheme scheme that is designed to make the price of a portfolio of derivatives insensitive to small changes in the price of the underlying asset. European Option: An option that can be exercised only at the end of its life. Exercise price: The price at which the underlying asset may be bought or sold in an option contract. Expiration Date: The end of life of a contract. Forward Exchange rate: The forward price of one unit of a foreign currency. Gamma: The rate of change of delta with respect to the asset price. Hedge: A trade designed to reduce risk. Derivatives and Risk Management61 Glossary Historic Volatility: A volatility estimated from historic data. Implied Volatility: Volatility implied from an option price using the Black- Scholes or a similar model. In-the-Money-Option: Either (a) a call option where the asset price is greater than the strike price or (b) a put option where the asset price is less than the strike price. Intrinsic Value: For a call option, this is the greater of the excess of the asset price over the strike price and zero. For a put option, it is the greater of the excess of the strike price over the asset price and zero. Out-of-the-Money Option: Either (a) a call option where the asset price is less than the strike price or (b) a put option where the asset price is greater than the strike price. Put-Call Parity: The relationship between the price of a European call option and the price of a European put option when they have the same strike price and maturity date. Put Option: An option to sell an asset for a certain price by a certain date. Derivatives and Risk Management62 Glossary Quanto: A derivative where the payoff is defined by variables associated with one currency but is paid in another currency. Spot Price: The price for immediate delivery. Theta: The rate of change of the price of an option or other derivative with the passage of time. Time Value: The value of an option arising from the time left to maturity (equals an options price minus its intrinsic value). Vega: The rate of change in the price of an option or other derivative with volatility. Volatility: A measure of the uncertainty of the return realised on an asset. Writing an option: Selling an option. Derivatives and Risk Management63 Nei Jing is the concept that taking medicines for an illness is like digging a well when thirsty 63