Fundamentals of Risk Management and different types of risk management tools

1. Derivatives B.V.Raghunandan,SVSCollege, Bantwal-Karnataka-India

2. Derivatives: Meaning Derivative is a financial instrument that derives its value from an underlying asset According to Wikipedia,” a derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying).It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency”.

3. Objectives/Purpose/Benefits/Uses of Derivatives Investing Hedging Asset Allocation Indexing International Access Market Timing Tax Minimisation Cash Management

4. Underlying/Underlying Asset Index Individual Stock Commodities: Metals, Minerals, Agricultural Commodities Interest Rate Contracts Forex Weather Climate Control (Carbon Trading)

5. Types of Derivatives

6. Over-the-Counter Contracts: Forward Contracts Forward Contract is a person-to-person agreement to buy or sell a specified asset of a specified quality at a specified time in the future at a predetermined price John C.Hull, ”it is an agreement to buy or sell an asset at a certain time in the future for a certain price” A.N.Sridhar, ”Forward contracts are agreements directly entered into between a buyer and a seller, calling for delivery of a specified amount of a specified asset at a specified, future date”

7. Features of a Forward Contract OTC Contract Customised terms (not standarsdised) Delivery Based Contract Settlement is essentially between the original parties No mechanism to guarantee the settlement Price and Settlement are not public knowledge

8. Limitations of Forward Markets No institutional Framework to conduct the trading Liquidity Risk (No third part enters at the time of settlement) Default Risk/Credit Risk/Counter-party Risk

9. Exchange Traded: Futures Graham Bannock, ”Future is a fixed and binding contract for standard amount to be sold at a fixed price at a fixed future date” Dr.N.R.Parasuraman,”A futures contract is a standardised agreement guaranteed by an exchange for a specified underlying asset for a specified quantity at a specified time”

10. Characteristics of Futures Exchange Traded Standardised Terms (underlying, quantity, quality, price and settlement date) Settlement through Reversal Higher level of Liquidity Counter-party Risk is borne by CCIL Daily settlement and margin payments

11. Differences between Forward and Futures Forward OTC Product Customised Terms Settlement at any time Delivery based contract Illiquid contract No Guaranteed Settlement No margin requirement No public knowledge Futures Exchange traded Standardised terms Daily settlement Reversal of transactions Liquid contract Settlement guaranteed by Exchange Margin requirement Public knowledge

12. Exchange-Traded: Options David Shirreff, ”An option is the right, but not the obligation, to buy or sell something, at a set price at a future date” Manish Bansal, “An option is a right the option seller gives to the option buyer to buy or sell an underlying asset at a predetermined price, within or at the end of a specified period”

13. Features of Options Exchange Traded Product Standardised terms Buyer gets the right and not the obligation Buyer may exercise the right or elso there is no settlement As in an insurance contract, the buyer has to pay a premium to the seller (option writer) Exercise at a future date (European Option) or within a specified period (American Option)

14. Differences between Forward Contracts and Options Forward Contract OTC Contract Customised terms Delivery based contracts Illiquidity Counter-part Risk All the parties have obligations No premium is involved Option Contracts Exchange traded Standardised terms No delivery High level of liquidity Counter-party risk is borne by the exchange Buyer has no obligation There is option premium

15. Differences between Futures and Options Futures Parties have rights and obligations There is an initial margin payment There are also other margins There is daily settlement through marked to market Compulsory settlement Options 1. Option buyer has no obligation 2. No margin is payable 3. There is a payment of premium 4. There is an exercise at a fixed period or within a fixed period 5. There is no settlement, if the buyer does not exercise the option

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