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Fundamentals of Risk Management and different types of risk management tools

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  1. 1. Derivatives<br />B.V.Raghunandan,SVSCollege,<br />Bantwal-Karnataka-India<br />
  2. 2. Derivatives: Meaning<br />Derivative is a financial instrument that derives its value from an underlying asset<br />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”. <br />
  3. 3. Objectives/Purpose/Benefits/Uses of Derivatives<br />Investing<br />Hedging<br />Asset Allocation<br />Indexing<br />International Access<br />Market Timing<br />Tax Minimisation<br />Cash Management<br />
  4. 4. Underlying/Underlying Asset<br />Index<br />Individual Stock<br />Commodities: Metals, Minerals, Agricultural Commodities<br />Interest Rate <br />Contracts<br />Forex<br />Weather<br />Climate Control <br />(Carbon Trading)<br />
  5. 5. Types of Derivatives<br />
  6. 6. Over-the-Counter Contracts: Forward Contracts<br />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<br />John C.Hull, ”it is an agreement to buy or sell an asset at a certain time in the future for a certain price”<br />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”<br />
  7. 7. Features of a Forward Contract<br />OTC Contract<br />Customised terms (not standarsdised)<br />Delivery Based Contract<br />Settlement is essentially between the original parties<br />No mechanism to guarantee the settlement<br />Price and Settlement are not public knowledge<br />
  8. 8. Limitations of Forward Markets<br />No institutional Framework to conduct the trading<br />Liquidity Risk (No third part enters at the time of settlement)<br />Default Risk/Credit Risk/Counter-party Risk<br />
  9. 9. Exchange Traded: Futures<br />Graham Bannock, ”Future is a fixed and binding contract for standard amount to be sold at a fixed price at a fixed future date”<br />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” <br />
  10. 10. Characteristics of Futures<br />Exchange Traded<br />Standardised Terms (underlying, quantity, quality, price and settlement date)<br />Settlement through Reversal<br />Higher level of Liquidity<br />Counter-party Risk is borne by CCIL<br />Daily settlement and margin payments<br />
  11. 11. Differences between Forward and Futures<br />Forward<br />OTC Product<br />Customised Terms<br />Settlement at any time<br />Delivery based contract<br />Illiquid contract<br />No Guaranteed Settlement<br />No margin requirement<br />No public knowledge <br />Futures<br />Exchange traded<br />Standardised terms<br />Daily settlement<br />Reversal of transactions<br />Liquid contract<br />Settlement guaranteed by Exchange<br />Margin requirement<br />Public knowledge<br />
  12. 12. Exchange-Traded: Options<br />David Shirreff, ”An option is the right, but not the obligation, to buy or sell something, at a set price at a future date”<br />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” <br />
  13. 13. Features of Options<br />Exchange Traded Product<br />Standardised terms<br />Buyer gets the right and not the obligation<br />Buyer may exercise the right or elso there is no settlement<br />As in an insurance contract, the buyer has to pay a premium to the seller (option writer)<br />Exercise at a future date (European Option) or within a specified period (American Option)<br />
  14. 14. Differences between Forward Contracts and Options<br />Forward Contract<br />OTC Contract<br />Customised terms<br />Delivery based contracts<br />Illiquidity<br />Counter-part Risk<br />All the parties have obligations<br />No premium is involved<br />Option Contracts<br />Exchange traded<br />Standardised terms<br />No delivery <br />High level of liquidity<br />Counter-party risk is borne by the exchange<br />Buyer has no obligation<br />There is option premium<br />
  15. 15. Differences between Futures and Options<br />Futures<br />Parties have rights and obligations<br />There is an initial margin payment<br />There are also other margins<br />There is daily settlement through marked to market<br />Compulsory settlement<br />Options<br />1. Option buyer has no obligation<br />2. No margin is payable<br />3. There is a payment of premium<br />4. There is an exercise at a fixed period or within a fixed period<br />5. There is no settlement, if the buyer does not exercise the option<br />
  16. 16. THANK YOU<br />