RISK IS THE BASIS OF BANKING…TO WIN WITHOUT RISK IS TO TRIUMPH WITHOUT GLORY……… No NORisk !!!! GAIN!!
INTRODUCTION- RISK MANAGMENT Risk management is a discipline that helps bringing risks to manageable extent . One risk does not get transformed into undesirable risk. PLAYERS: Hedgers, Speculators and Arbitrageurs - Market Role Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling. (E.g. Banks) Speculators provide liquidity and depth to the market. Arbitrageurs
VARIOUS TYPES OF RISKS IN BANKS Solvency Risks- Risk of total financial failure of a bank. Liquidity Risk- Inability to meet the repayment requirements Credit Risk- Loss of Bank as a result of default Interest Rate Risk- Changes in Interest rate. Price Risks- Risk of loss/gain in value of assets & liabilities due to volatility in exchange rates. Operating Risks- Risks arising from out of failures in operations, supporting system, sabotage, fraud etc. Market & Foreign exchange Risk.
PROCESS OF RISK MANAGEMENT IN BANKS Identification of risks Quantification of risks Policy Formulation Strategy Formulation Derivatives come in play Monitoring Risks
HISTORY OF DERIVATIVES AND THE MARKET IN INDIAAccording to Mr. Asani Sarkar’s research work,Derivatives market has been in existence in India since1875He also mentions that in early 1900s India had thelargest Futures IndustryIn 1952, Indian Government banned the options andfutures tradingBut, by 2000 various reforms assisted in lifting allsuch bans and the derivatives market is booming sincethen
Contd.. The exchange traded derivative market is the largest in terms of number of contracts made In 2004, the daily trading value was 30 billion USD The commodities eligible for futures trading was 8 and in 2004 it was increased to 80
DERIVATIVES Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee and what have you. EX: derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.
Financial derivatives are financial instruments whose prices are derived from the prices of other financial instruments which are also know as underlying. It relates to equities, loans, bonds, interest rates and currencies.Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as:a) “a security derived from a debt instrument, share, loan whether secured or unsecured, riskinstrument or contract for differences or any other form of security;b) “a contract which derives its value from the prices, or index of prices, of underlying securities”.
MOTIVES OF USING DERIVATIVES Spreads trade Currency risk management. Interest risk Real time trading in the market ( Treasury Activities)
ApplicAtions of finAnciAl DerivAtives1. Management of risk:2. Efficiency in trading:3. Speculation:4. Price discover:5. Price stabilization function:
strAteGies of risKMAnAGeMent in BAnKs. Hedging the Risk . – Derivatives Forwards Futures Options Swaps Credit Derivatives (Not available in India)
eXAMple Jewelry manufacturer Gold buyer agrees to buy gold at Rs. 600 (the forward or delivery price) three months from now (the delivery date) from gold mining concern Gold seller. This is an example of a forward contract. No money changes hands between Gold buyer and Gold seller at the time the forward contract is created. Rather, Gold buyer’s payoff depends on the spot price at the time of delivery. Suppose that the spot price reaches Rs. 610 at the delivery date. Then Gold buyer gains Rs. 10 on his forward position (i.e. the difference between the spot and forward prices) by taking delivery of the gold at Rs. 600..
feAtures of forwArD contrAct… It is a negotiated contract between two parties and hence exposed to counter party risk. Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc. A contract has to be settled in delivery or cash on expiration date. In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.
the stAnDArD feAture in Any futures contrAct Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basisEX: when you are dealing in March 2002 Satyam futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 1,200 shares of Satyam, the contract would expiry on March 28, 2002, the price is quoted per share, the tick size is 5 paise per share or (1200*0.05) = Rs60 per contract/ market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.
Motives BehinD usinG futuresHedging: It provides an insurance against an increase in the price.The futures market has two main types of foreseeable risk: - price risk - quantity risk
Interest rate FuturesAn interest rate futures contract is anagreement to buy or sell a standard quantityof specific interest bearing instruments, at apredetermined future date and a priceagreed upon between parties
OPtIOnsOptions contracts grant their purchasers theright but not the obligation to buy or sell aspecific amount of the underlying at aparticular price within a specified period.
OPtIOns termInOlOgy …Commodity optionsStock OptionsBuyer of an optionWriter of an optionCall optionPut optionOption price
SWAPSSwaps are derivatives involving exchangeof cash flows over time, typically betweentwo parties. One party makes a paymentto the other depending upon whether aprice is above or below a reference pricespecified in the swap contract.
ChArACteriStiCS of SWAPS1. Basically a forward It is combination of Forwards. It has all the properties of Forward contract.2. Double coincidence of wants It requires that two parties with equal and opposite needs must come into contact with each other.3. Comparative credit advantage Borrowers enjoying comparative credit advantage in floating rate debts will enter into swap agreement.
Contd..4. Flexibility Lenders have the flexibility to exchange floating rates according to the conditions prevailing in the market.5. Necessity of an intermediary It requires two counter parties with opposite and matching needs. Thus it has created the necessity of an intermediary.
Contd..6. Settlements Even though the principal amount is mentioned it is not exchanged. Here stream of fixed rate is exchanged for floating rate interest.7. Long term agreement Forwards are for short term. Long dated forward contracts are not preferred because they involve more risk.
BuSineSS GroWth of DerivAtiveS At nSe from 2000-2009
imPortAnCe To minimize risk. To protect the interest of individual and institutional investors. Offers high liquidity and flexibility. Does not create new risk and minimizes existing ones. Lowers transaction cost. Provides information on market movement. Provides wide choice of hedging. Convenient, low cost and simple to operate.