This document explains the basics of risk, derivative tools and how these tools can be used to manage risk in an organisation. It has real life case studies showing how companies have failed by using derivatives incorrectly. The document also has a success case study wherein a company had effectively used derivatives to manage its risk.
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RISK MANAGEMENT USING
DERIVATIVES AS A TOOL.
Submitted to
IN PARTIAL FULFILLMENT OF THE REQUIREMENT TO
AWARD THE DEGREE OF
MASTERS IN FINANCIAL TECHNOLOGY
Submitted by
KRUTI D SHAH
MFT BATCH (2017-2019)
MFT 1716
Under the Guidance of: Prof. Snehal Soni
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ACKNOWLEDGEMENT
It gives me immense pleasure to submit my research project on “Risk Management
using derivatives as a tool” as a part of Masters in Financial Technology.
To accomplish the research project, there were many people along way who have
been responsible for guiding, advising, encouraging me time to time. I am really
grateful to them. I am thankful to BSE Institute LTD. who gave this wonderful
opportunity to complete the research work on the topic I desired.
I would like to express my special thanks of gratitude to my guide Prof. Snehal Soni
for giving valuable guidance and support throughout my research work. Last but not
the least, I would like to thank my parents and friends who helped me in finalizing
this project within the limited time frame.
Miss. Kruti D Shah
(Research Candidate)
Place: Mumbai
Date:22nd
May 2019
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CERTIFICATE
This is to certify that Miss. Kruti D Shah, Roll no. MFT 1716, student of BSE
Institute Limited has successfully completed a research project on “Risk
Management using Derivatives as a tool” under the guidance and supervision of
Prof. Snehal Soni in the academic year 2017-2019.
Prof. Snehal Soni Miss. Kruti D Shah
(Research Guide) (Student)
Date:22nd
May 2019
Place: Mumbai
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DECLARATION
I hereby declare that the research project entitled “Risk Management using
Derivatives as a tool” submitted by me in the partial fulfillment of the requirement
for the award of Masters in Financial Technology. The project report is my original
work and I have not submitted to any other university or institute for the award of
any degree or diploma.
Miss. Kruti D Shah
Roll No: MFT 1716
Batch: 2017-19
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Table of Contents
ACKNOWLEDGEMENT...................................................................................................................................2
CERTIFICATE..................................................................................................................................................3
DECLARATION ...............................................................................................................................................4
INTRODUCTION.............................................................................................................................................7
WHAT IS RISK?...............................................................................................................................................7
TYPES OF RISKS..........................................................................................................................................8
RISK VS. UNCERTAINTY .......................................................................................................................10
WHAT IS RISK MANAGEMENT?...........................................................................................................11
APPROACHES TO RISK MANAGEMENT ...............................................................................................12
DERIVATIVES ...............................................................................................................................................13
WHAT ARE DERIVATIVES?...........................................................................................................................13
TYPES OF DERIVATIVES IN THE INDIAN MARKET........................................................................................15
Equity Derivatives ...................................................................................................................................15
Commodity Derivatives...........................................................................................................................15
Currency Derivatives...............................................................................................................................16
Interest Rate Derivatives.........................................................................................................................16
Other Derivatives....................................................................................................................................17
Generic Derivatives Products..................................................................................................................17
Forward Contract................................................................................................................................18
Swaps ..................................................................................................................................................18
Warrants .............................................................................................................................................19
Futures Contract .................................................................................................................................19
USE OF DERIVATIVES...................................................................................................................................20
RISKS IN DERIVATIVES TRADING .................................................................................................................24
IMPLICATIONS FOR HEDGING.....................................................................................................................25
Upside and Downside Risks ....................................................................................................................26
REVIEW OF LITERATURE..............................................................................................................................28
RESEARCH METHODOLOGY ........................................................................................................................30
CASE STUDIES..............................................................................................................................................32
1. BMW ...............................................................................................................................................32
2. METALLGESELLSCHAFT AG..............................................................................................................36
3. ORANGE COUNTY............................................................................................................................40
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4. BARINGS BANK................................................................................................................................43
5. BLACK MONDAY – NEW YORK STOCK EXCHANGE..........................................................................46
FINDINGS AND CONCLUSION......................................................................................................................49
BIBLIOGRAPHY ............................................................................................................................................51
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RISK MANAGEMENT USING DERIVATIVES AS A TOOL
INTRODUCTION
WHAT IS RISK?
Risk implies future uncertainty about deviation from expected earnings or expected
outcome. Risk measures the uncertainty that an investor is willing to take to realize
a gain from an investment. Risk includes the possibility of losing some or all of the
original investment. Different versions of risk are usually measured by calculating
the standard deviation of the historical returns or average returns of a specific
investment
“Risk is a condition in which there is a possibility of an adverse deviation from
desired outcome that is expected or hoped for.” In most of the risky situations, two
elements are commonly found;
a. The outcome is uncertain i.e. there is a possibility that one or other(s) may occur.
Therefore, logically there are at least two possible outcomes for a given situation.
b. Out of the possible outcomes, one is unfavorable or not liked by the individual or
the analyst.
A high standard deviation indicates a high degree of risk. Many companies allocate
large amounts of money and time in developing risk management strategies to help
manage risks associated with their business and investment dealings. A key
component of the risk management process is risk assessment, which involves the
determination of the risks surrounding a business or investment.
A fundamental idea in finance is the relationship between risk and return. The greater
the amount of risk an investor is willing to take, the greater the potential return.
Investors need to be compensated for taking on additional risk. For example, a U.S.
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Treasury bond is considered one of the safest, or risk-free, investments and when
compared to a corporate bond, provides a lower rate of return. A corporation is much
more likely to go bankrupt than the U.S. government. Because the risk of investing
in a corporate bond is higher, investors are offered a higher rate of return.
There are several ways to measure risk. Measuring risk allows investors and traders
to hedge some of that risk away using various strategies including employing
derivatives positions.
Individuals also have their own willingness and ability to take risk (risk-tolerance)
based on objective factors like income and age as well as subjective factors like
personality, personal experience, and emotion.
TYPES OF RISKS
Systematic
Risk
Market
Risk
Interest
Rate Risk
Inflation
Risk
Exchange
Rate Risk
Political
Risk
Unsystematic
Risk
Business
Risk
Internal
Risk
External
Risk
Financial
Risk
Credit
Risk
Currency
Risk
Country
Risk
Liquidity
Risk
Operation
al Risk
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All investment assets can be separated by two categories: systematic
risk and unsystematic risk. Market risk, or systematic risk, affects a large number
of asset classes, whereas specific risk, or unsystematic risk, only affects an industry
or particular company.
Systematic risk is the risk of losing investments due to factors, such as political risk
and macroeconomic risk, that affect the performance of the overall market. Market
risk is also known as volatility and can be measured using beta. Beta is a measure of
an investment's systematic risk relative to the overall market.
Market risk cannot be mitigated through portfolio diversification. However, an
investor can hedge against systematic risk. A hedge is an offsetting investment used
to reduce the risk in an asset.
For example, suppose an investor fears a global recession affecting the economy
over the next six months due to weakness in gross domestic product growth. The
investor is long multiple stocks and can mitigate some of the market risk by buying
put options in the market.
The Great Recession also provides an example of systematic risk. Anyone who was
invested in the market in 2008 saw the values of their investments change drastically
from this economic event. The Great Recession affected asset classes in different
ways, as riskier securities (e.g., those that were more leveraged) were sold off in
large quantities, while simpler assets, such as U.S. Treasury bonds, became more
valuable.
Specific risk, or diversifiable risk, is the risk of losing an investment due to company
or industry-specific hazard. Unlike systematic risk, an investor can only mitigate
against unsystematic risk through diversification. An investor uses diversification to
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manage risk by investing in a variety of assets. He can use the beta of each stock to
create a diversified portfolio.
For example, suppose an investor has a portfolio of oil stocks with a beta of 2. Since
the market's beta is always 1, the portfolio is theoretically 100% more volatile than
the market. Therefore, if the market has a 1% move up or down, the portfolio will
move up or down 2%. There is risk associated with the whole sector due to the
increase in supply of oil in the Middle East, which has caused oil to fall in price over
the past few months. If the trend continues, the portfolio will experience a significant
drop in value. However, the investor can diversify this risk since it is industry-
specific.
The investor can use diversification and allocate his fund into different sectors that
are negatively correlated with the oil sector to mitigate the risk.
For example, the airlines and casino gaming sectors are good assets to invest in for
a portfolio that is highly exposed to the oil sector. Generally, as the value of the oil
sector falls, the values of the airlines and casino gaming sectors rise, and vice versa.
Since airline and casino gaming stocks are negatively correlated and have negative
betas in relation to the oil sector, the investor reduces the risks that affect his
portfolio of oil stocks.
RISK VS. UNCERTAINTY
Risk is defined as a calculable probability of loss, such as a standard deviation or
using a technique such as value at risk (VaR). Because it is measurable and
probabilistic, risk can be hedged or insured against, and so reduced. Uncertainty, on
the other hand, refers to circumstances where the outcomes or potential probabilities
for a loss are unknown and unknowable. Because uncertainty cannot be calculated
it cannot be fully hedged against.
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But how do you manage risk? And what is risk management?
WHAT IS RISK MANAGEMENT?
In the financial world, risk management is the process of identification, analysis and
acceptance or mitigation of uncertainty in investment decisions. Essentially, risk
management occurs when an investor or fund manager analyzes and attempts to
quantify the potential for losses in an investment and then takes the appropriate
action (or inaction) given his investment objectives and risk tolerance.
Risk management occurs everywhere in the financial world. It occurs when an
investor buys low-risk government bonds over riskier corporate bonds, when a fund
manager hedges his currency exposure with currency derivatives, and when a bank
performs a credit check on an individual before issuing a personal line of credit.
Stockbrokers use financial instruments like options and futures, and money
managers use strategies like portfolio and investment diversification to mitigate or
effectively manage risk.
Inadequate risk management can result in severe consequences for companies,
individuals, and for the economy. For example, the subprime mortgage meltdown in
2007 that helped trigger the Great Recession stemmed from poor risk-management
decisions, such as lenders who extended mortgages to individuals with poor credit,
investment firms who bought, packaged, and resold these mortgages, and funds that
invested excessively in the repackaged, but still risky, mortgage-backed securities
(MBS).
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APPROACHES TO RISK MANAGEMENT
Two approaches can be used to manage risk:
Do nothing: This means the company will ignore all the risks. This is appropriate if
the exposure is very small or if the cost of managing the risk exceeds the benefits
that might be reaped from doing so.
Cover everything: This means that the company will take a position in a derivative
instrument to manage every exposure. This approach allows the company to manage
all the risks that can be identified and sufficiently quantified.
The first alternative is passive, whereas the second alternative is active risk
management. In active risk management, the business leaves exposures uncovered
when prices or rates appear to be moving in its favor and covers them when the
movement in prices or rates could lead to losses. This process is also known as
selective hedging. The merits of each of these alternatives will have to be weighed
against the costs in order to achieve the best possible solution at that moment The
success of active management relies on the ability of the business to make reasonably
accurate forecasts on future movements in prices, interest rates, of exchange rates.
In managing risks, businesses use financial instruments such as derivatives to modify
the uncertainty of future cash flows. If financial instruments are used to decrease the
uncertainty of future cash flows, the companies are said to hedge. If the instruments
are used to increase the uncertainty of the future cash flows, they are said to
speculate. It should be noted that a decision to not use instruments to cover an
existing exposure is also a form of speculation. Using derivatives to hedge business
risks is in itself a risky proposition. If one enters into speculative activity using
derivatives, the speculator also faces risks.
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DERIVATIVES
WHAT ARE DERIVATIVES?
The word "DERIVATIVES" is derived from the word itself derived of an underlying
asset. It is a future image or copy of an underlying asset which may be shares, stocks,
commodities, stock indices, etc.
Derivatives is a financial product (shares, bonds) any act which is concerned with
lending and borrowing (bank) does not have its value borrow the value from
underlying asset/ basic variables
Derivatives is derived from the following products.
A. Shares
B. Debentures
C. Mutual funds
D. Gold
E. Steel
F. Interest rate
G. Currencies
Derivatives is a type of market where two parties are entered into a contract one is
bullish and other is bearish in the market having opposite views regarding the
market. There cannot be a derivatives having same views about the market. In short
it is like an INSURANCE market where investors cover their risk for a particular
position.
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Derivatives are financial contracts of pre-determined fixed duration, whose values
are derived from the value of an underlying primary financial instrument,
commodity or index, such as: interest rates, exchange rates, commodities, and
equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure
to changes in foreign exchange rates, interest rates, or stock indexes or commonly
known as risk hedging. It is the most important aspect of derivatives and also its
basic economic purpose. There has to be counter party to hedgers and they are
speculators. Speculators don't look at derivatives as means of reducing risk but it's a
business for them. Rather he accepts risks from the hedgers in pursuit of profits.
Thus for a sound derivatives market, both hedgers and speculators are essential
Derivatives trading has been a new introduction to the Indian markets. It is, in a
sense promotion and acceptance of market economy, that has really contributed
towards the growing awareness of risk and hence the gradual introduction of
derivatives to hedge such risks
Initially derivatives were launched in America called Chicago. Then in 1999, RBI
introduced derivatives in the local currency Interest Rate markets, which have not
really developed, but with the gradual acceptance of the ALM guidelines by banks,
there should be an instrumental product in hedging their balance sheet liabilities
The first product which was launched by BSE and NSE in the derivatives market
was index futures
Derivatives can trade over-the-counter (OTC) or on an exchange. OTC derivatives
constitute a greater proportion of the derivatives market. OTC-traded derivatives,
generally have a greater possibility of counterparty risk. Counterparty risk is the
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danger that one of the parties involved in the transaction might default. These parties
trade between two private parties and are unregulated.
Conversely, derivatives that are exchange-traded are standardized and more heavily
regulated.
TYPES OF DERIVATIVES IN THE INDIAN MARKET
At present, the Indian market trades in both exchange – traded and over – the –
counter derivatives on various asset classes including both equity and debt –
commodities, currencies, etc. The evolution of derivatives market in the said asset
classes is as follows:
Equity Derivatives
India joined the league of exchange – traded derivatives in 2000 when futures was
introduced on both the exchanges – NSE and BSE. An equity derivative is a financial
instrument whose value is based on equity movements of the underlying asset. For
example, a stock option is an equity derivative, because its value is based on the
price movements of the underlying stock. Investors can use equity derivatives to
hedge the risk associated with taking long or short positions in stocks, or they can
use them to speculate on the price movements of the underlying asset.
Commodity Derivatives
Commodity derivatives simply mean a derivative contract where the underlying
assets are commodities like precious metals (platinum, gold, silver), other metals
(tin, copper, lead, steel etc.), agro products (coffee, wheat, cotton, pepper etc.), and
energy products (crude oil, natural gas, heating oil etc.)
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The Forward Contract Regulation Act (FCRA) governs commodity derivatives in
the country. The FCRA specifically prohibits OTC commodity derivatives.
Accordingly, at this time we only have exchange – traded commodity derivatives.
Furthermore, FCRA does not even allow options on commodities. Therefore, at
present, India trades only exchange – traded futures. India began trading in
commodity derivatives through two nationwide online commodity exchanges – the
National Commodities and Derivatives Exchange (NCDEX) and the Multi
Commodity Exchange (MCX).
Currency Derivatives
Currency derivatives are a contract between the seller and buyer, whose value is to
be derived from the underlying asset i.e. the currency value. A derivative based on
currency exchange rate is an agreement that two currencies can be exchanged in a
specific quantity of a particular currency pair at a future date. Currency Derivatives
can be Future and Options contracts which are similar to the Stock Futures and
Options but the underlying happens to be currency pair (i.e. USDINR, EURINR,
JPYINR OR GBPINR) instead of Stocks. Currency Derivatives are available on four
currency pairs viz. US Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and
Japanese Yen (JPY). Currency options are currently available on US Dollars.
Interest Rate Derivatives
An interest-rate derivative is a financial instrument with a value that increases and
decreases based on movements in interest rates. Interest-rate derivatives are often
used as hedges by institutional investors, banks, companies and individuals to
protect themselves against changes in market interest rates, but they can also be used
to increase or refine the holder’s risk profile.
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Other Derivatives
Indian market participants have also shown some inters in credit and weather
derivatives. Slowly but surely, these products too are making strides in Indian
financial markets. Securitization and exchange-traded funds (ETFs) linked to
currencies and bullion are being widely discussed.
Generic Derivatives Products
The emergence of a market for derivative products can be traced to the requirement
of risk-averse economic agents, to guard themselves against uncertainties arising out
of fluctuations in asset prices. It is possible to create certainty by partially or fully
transferring the price risk in assets from one entity to another, through the use of
derivative products. As instruments of risk management, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow
situations of risk-averse market participants.
Over the
counter
Forwards Swaps
Interest Rate
Swaps
Currency
Swaps
Swaptions
Credit Default
Swaps
Warrants
Leaps
Baskets
Exchange
traded
Futures Options
Call
Put
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The most commonly used derivatives contracts are forwards, futures and options,
which I have discuss in detail further. Here we take a brief look at various derivatives
contracts that have come to be used.
Forward Contract
A forward contract is one-to-one, bipartite/tripartite contract, which is to be
performed mutually by the contracting parties, in future, at the terms decided upon,
on the contract date. Thus, a forward contract is a customized contract. In other
words, a forward contract is an agreement to buy or sell an asset on a specified future
date for a specified price. One of the parties to the contract assumes a long position,
i.e. agrees to buy the underlying asset while the other assumes a short position, i.e.
agrees to sell the asset. A forward contract is an OTC product.
Swaps
Swaps are private agreements between two parties to exchange one stream of future
cash flows for another stream of cash flows in accordance with a pre-arranged
formula. The agreement provides details of how the cash flows will be calculated
and the dates on which the cash flows will be exchanged. At the time the contract is
entered into, at least one of these cash flows will be determined on the basis of an
uncertain variable such as interest rate, exchange rate, equity price, or commodity
price, while the other could either be a fixed payment or be determined on the basis
of another uncertain variable.
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Swap contracts are private, OTC agreements, and no exchange exists for swap
contracts. There are no regulations governing swap contracts, and they can be
customized to the needs of the parties.
Warrants
Is a derivative that gives investor an option to buy or sell a stated number of shares
of an underlying instrument at a specified price (exercise or strike price) within a
specified time period. Generally issued by listed companies as a “sweetener”
attached to an offering of bonds or rights issues for shares. Warrants allow the issuer
to obtain a lower interest rate on its bond issue, hence lower its financing cost. They
are detachable from the host instrument and may be listed and traded separately.
They are traded on SGX-Securities Trading Ltd. Warrant holders do not receive nor
pay any dividend income or cash distributions even if the underlying instrument pays
a dividend or cash distribution. A company warrant is a long-dated call option as its
maturity is typically 3 to 5 years (compared to options and structured warrants have
expiration dates of less than 1 year).
Futures Contract
Futures contracts are standardized forward contracts or the futures market is simply
an extension of the forward market. In order to make the contracts attractive to a
large set of market participants, they have standardized these contracts. To further
generate liquidity in these contracts by engendering confidence among market
participants, exchanges have persuaded their clearing corporations to guarantee
these trades. Futures came into existence in order to address the issues of illiquidity
and counter party risk in forward contracts. Basically, futures contracts are
standardized forward contracts traded on the exchanges and settled through a
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clearing agency of the exchanges. The clearing agency also guarantees the settlement
of these trades.
An option is a right given by the option writer/seller to the option buyer/ holder to
buy or sell an underlying asset at a predetermined price within or at the end of a
specified period. Therefore, an option is a contract that offers the buyers an
opportunity to exercise the right (buy or sell the underlying) only if it is favorable to
them. Otherwise, they may let the right expire.
Options can be categorized as call and put options. An option, which gives the buyer
a right to buy the underlying asset, is called a call option and an option, which gives
the buyer a right to sell the underlying asset, is called a put option. Further, an option,
which is exercisable at any time on or before the expiry date/day, is called an
American option and the option, which is exercisable only on its expiry, is called a
European option.
USE OF DERIVATIVES
Derivatives markets help to reallocate risk among investors. A person who wants to
reduce risk, can transfer some of that risk to a person who wants to take more risk.
Consider a risk-averse individual. He can obviously reduce risk by hedging. When
he does so, the opposite position in the market may be taken by a speculator who
wishes to take more risk. Since people can alter their risk exposure using futures and
options, derivatives markets help in the raising of capital. As an investor, you can
always invest in an asset and then change its risk to a level that is more acceptable
to you by using derivatives.
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This is most important function of derivatives. Risk management is not about the
elimination of risk rather it is about the management of risk. Financial derivatives
provide a powerful tool for limiting risks that individuals and organizations face in
the ordinary conduct of their businesses. It requires a thorough understanding of the
basic principles that regulate the pricing of financial derivatives. Effective use of
derivatives can save cost, and it can increase returns for the organizations.
Derivatives are mainly used for risk management. Companies face risks in the form
of changes in the prices of their inputs and outputs, changes in interest rates, and
changes in currency exchange rates. Since these risks are inherent in any business,
it is important that they are managed effectively. Generally, companies try to reduce
the risk of price variability. The process of reducing risks is known as hedging. Thus,
the major use of derivatives is in hedging. In hedging, the manager tries to fix the
following: the price at which the business will buy or sell a commodity or service,
the price at which the business will buy or sell a financial instrument, the interest
rate at which the business will borrow or lend, and the currency exchange rate at
which the business will buy or sell foreign currency.
Derivatives are also used for speculation. Since the price of derivatives is based on
the expected future value of the underlying assets, one can speculate on the value of
the underlying assets in the future. Derivatives can provide a better and cheaper
vehicle for speculation as compared to speculating directly with the underlying
assets. For example, assume that gold is selling at INR 1,500 per gram today. If you
believe that gold price is likely increase in the next three days, you can speculate
using this information. One way is to buy the gold today at INR 1,500 per gram and
sell the same when the price increases as expected. If the price increases as expected,
say to INR 1,550, you can sell the gold at INR 1,550 and make a profit of INR 50.
However, this strategy requires an investment of INR 1,500 today. Alternatively,
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you can enter into a futures contract. As will be shown in Chapter 5, futures will also
provide a profit of INR 50, but the amount of investment will be very low. Most
speculators use derivatives to make profits. It is to be noted that speculation is a risky
activity, and if the price does not move as expected, it can result in losses. In fact,
most of the losses associated with derivatives (listed in the beginning of the chapter)
were due to speculations.
Derivatives are also used for the purpose of arbitrage. An arbitrage opportunity
exists when one can make non-zero profit with no net investment or risk. Since
futures contract values are based on the value of the underlying asset, there should
be a relationship between the value of the futures and the value of the underlying
asset. If, at any time, this relationship is violated, there will be an arbitrage
opportunity. For example, assume that the price of gold in the market is INR 15,000
and the theoretical value of gold futures is INR 15,500. If the futures are actually
priced at INR 15,800, there will be an arbitrage opportunity. An arbitrager can sell
the futures at INR 15,800. Of many arbitrageurs enter the market like this, the futures
price will fall to its theoretical value of INR 15,500, and the arbitrager can buy the
futures back at INR 15,500 and earn a profit of INR 300 with no risk at all. Arbitrage
is an important use of derivatives, and it provides stability to both the futures market
and the market for the underlying assets.
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In a nutshell derivative helps us to:
• Transfer of risk:
By far, the most important use of these derivatives is the transfer of market risk from
risk-averse investors to those with an appetite for risk. Risk-averse investors use
derivatives to enhance safety, while risk-loving investors like speculators conduct
risky, contrarian trades to improve profits. This way, the risk is transferred.
The primary use of derivatives is to hedge one’s positions i.e., to reduce or eliminate
the risk inherent in commodities, foreign currencies and financial assets. Farmers
who want to guarantee the prices of their future crop can sell them at any time in the
futures or forward market.
Exporters, exposed to foreign exchange risk, can reduce their risk using derivatives
(forward, futures, and options).
Pension funds who invest in securities can avoid disastrous consequences by buying
insurance in the form of put options.
The risk management benefits of derivatives are not limited to hedging one’s
exposure to risk but to a whole spectrum of risk-return combinations which can be
achieved using options. For example, these features allow one to protect themselves
in extremely volatile times like we are witnessing now.
• Earn money on shares that are lying idle:
So you don’t want to sell the shares that you bought for long term, but want to take
advantage of price fluctuations in the short term. You can use derivative instruments
to do so. Derivatives market allows you to conduct transactions without actually
selling your shares – also called as physical settlement.
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• Benefit from arbitrage:
When you buy low in one market and sell high in the other market, it called arbitrage
trading. Simply put, you are taking advantage of differences in prices in the two
markets.
• Protect your securities against:
Fluctuations in prices The derivative market offers products that allow you to hedge
yourself against a fall in the price of shares that you possess. It also offers products
that protect you from a rise in the price of shares that you plan to purchase. This is
called hedging.
RISKS IN DERIVATIVES TRADING
Earlier, a number of examples of the collapse of companies such as the Barings Bank
and Lehmann Brothers and the bankruptcy of organizations such as Orange County,
AIG, and LTCM due to their trading in derivatives were cited. But where does the
risk come from while trading in derivatives? When a hedger uses derivatives to
hedge, they are trying to reduce the risk of the prices going against them. In forward
contracts, futures contracts, and swap contracts, the price at which the future
exchange will take place is fixed. If the price moves against the hedger, they will
benefit from these contracts. On the other hand, if the prices move in favour of the
hedger, they will face a loss. Depending upon the volume of transaction, the losses
could be large.
Speculators use derivatives on the basis of their expectations of the future price
movement. In case they are correct in their assessments, they make profits. On the
other hand, if the assessments turn out to be wrong, they face losses while using
forward contracts, futures contracts, or swap contracts. Option contracts can also
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result in losses, even though the amount could be comparatively less when compared
to forward contracts, futures contracts, or swaps. This is particularly true when
speculators combine options to make money on the basis of their expectations of
future prices. If the price does not move as expected, options can also result in huge
losses. Recent developments in derivatives that include complex products such as
exotic derivatives and credit derivatives can also result in huge losses. These losses
arise because payment patterns are not very clear in these derivatives. Most of these
derivatives would result in payments when a particular event occurs. It is very
difficult to calculate the probability of such an event occurring or the amount that is
to be paid if that event occurs. Because of these factors, even sophisticated investors
find it very difficult to assess the risks of these exotic derivatives. In using
derivatives, therefore, it is important that one clearly understands the risks involved
while trading a particular derivative. If one cannot understand the conditions under
which payment would have to be made or the amount that would have to be paid, it
would be better not to enter into such derivative contracts. The popular adage
"Buyers Beware" also applies to derivatives.
IMPLICATIONS FOR HEDGING
Hedging risk is the process by which a financial manager tries to fix a price for a
future purchase or sale of a given asset. This can be accomplished by any of the four
following instruments: Forward Contracts, Futures Contracts Options Contracts
Swap Contracts When prices are volatile, they can either increase or decrease from
their current levels. Consider the case of a company planning to borrow money three
months from today. Because interest rate could change over time, it is not certain
what the interest rate might be when the company seeks to borrow. The interest rate
could rise, in which case it would be making a higher interest payment on the loan
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as compared to what it would be making if the borrowing took place today. On the
other hand, if the interest rate goes down, the amount of interest would be lower than
what it would be if the borrowing took place today. If the interest rate moves up, the
interest rate is said to move against the interests of the company, and if the interest
rate moves down, it is said to move in the company's favour. The direction of
movement of interest rate will have implications on hedging activities.
Upside and Downside Risks
Hedging with futures or forward contracts enables a company to fix the interest rate
at which it will borrow. For example, assume that the current interest rate is 8% and
the interest rate under a futures contract for borrowing three months later is 9%. In
this contract, the company is fixing the future interest rate at 9%, irrespective of what
the market interest rate will be after three months. However, market interest rates
can move in any direction. If the market interest rate was to rise to 10% after three
months, the decision to hedge and fix the rate at 9% would be considered fruitful.
On the other hand, if the interest rate moved only to 8.5%, the company would be
paying 9% interest on the loan under the futures contract; it would have had to pay
only 8.5% had it not hedged.
This example shows that the company benefits from hedging using futures contracts
only if the interest rate moves against the company. If the interest rate moves in favor
of the company, hedging becomes costly. When the interest rate moves against the
company, the firm is said to face a downside risk, and if the interest rate moves in
favor of the company, it is said to face an upside risk
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It is important that a business considers the implications of both upside and downside
risks. It is also important that a business uses hedging instruments when there is a
possibility of downside risk, as this would produce beneficial results. However, if
the price moves in favor or if there is a possibility of an upside risk, then that factor
should also be considered in taking a hedging decision. If the competitors of a
business consider the upside risk in their hedging decisions but the business does
not, then the competitors will gain an advantage, which could become crucial in the
survival of the business.
Futures contracts and forward contracts provide favorable results when a business
faces downside risks, but hedging using forwards and futures could be costly when
a business faces an upside risk. On the other hand, options contracts may provide
favorable results when the company faces either a downside risk or an upside risk.
This can be illustrated with an example.
Suppose the same company as in the previous example had entered into an options
contract to borrow at 9% in three months' time. If the actual interest rate were 10%
after three months, when the company actually borrows, the company would
exercise the right and borrow at 9%. If market interest rates were below 9%, say,
8.5%, the company could choose to not exercise the right and could instead borrow
at the lower market rate of 8.5%.
This example indicates that options provide protection against downside risks, and
at the same time they provide an upside potential. Because of this range of pay-off
possibilities, options are assets and they require an upfront investment in order to
buy them. The critical question then is whether the benefits provided by options are
worth their cost.
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REVIEW OF LITERATURE
Financial derivatives are so effective in reducing risk because they enable financial
Institutions to hedge that is, engage in a financial transaction that reduces or
eliminates risk When a financial institution has bought an asset, it is said to have
taken a long position, and this exposes the institution to risk if the returns on the
asset are uncertain. Conversely, if it has sold an asset that it has agreed to deliver to
another party at a Future date, it is said to have taken a short position, and this can
also expose the Institution to risk. Financial derivatives can be used to reduce risk
by invoking the following basic principle of hedging. It involves engaging in a
financial transaction that offsets a long position by taking an additional short
position, or offsets a short position by taking an additional long position. In other
words, if a financial institution has bought a security and has therefore taken a long
position, it conducts a hedge by contracting to sell that security (take a short position)
at some future date. Alternatively, if it has taken a short position by selling a security
that it needs to deliver at a future date, then it conducts a hedge by contracting to
buy that security (take a long position) at a future date. We look at how this principle
can be applied using forward and futures
There are three broad categories of participants in the Indian derivatives market -
hedgers, speculators and arbitrageurs. hedgers face risk associated with the price of
an assets. They use futures or options markets to reduce or eliminate this risk.
Speculates wish to bet on future movement in the price of an asset. features and
options contracts cangue them an extra leverage, they can increase both the potential
gains and losses in a speculative venture Arbitrageurs are in business to take
advantage of a discrepancy between prices in two different markets
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Derivative products initially emerged, as hedging devices against fluctuation in
commodity prices and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. In recent years, the market for financial
derivative has grown tremendously in terms of variety of instruments available. The
emergence of the market for derivative products, most notable forwards, futures and
options, can be traced back to the willingness of risk-averse economic agents to
guard themselves against uncertainties arising out of fluctuations in asset prices
Through the use of derivative products, it is possible to partially or fully transfer
price risks by locking in asset prices. as instrument of risk management, these
generally do not influence the fluctuations in the underlying asset prices
The book Derivatives and Financial Innovations helped me understand the tools of
derivatives and how the same are used to mitigate risks in the industry. The book
touched on all dimensions of futures and options trading, starting from basic
concepts to the complex trading strategies. After performing the research, I now have
a great understanding of the topic and so will all the readers have. The book also
explained the concepts with clear examples which made my understanding crystal
clear.
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RESEARCH METHODOLOGY
The research was conducted majorly using data from various secondary sources,
although a small part of the research was conducted using primary sources like one
to one conversation with derivatives strategists of small firms to understand the
hedging process.
The secondary data was collected from various libraries where the records are stored,
visits to various government organizations, the exchanges and intermediaries, from
international and national websites, from published data sources such as various
reports, periodicals, journals, books, magazines, research articles, newspapers,
annual reports, published research papers etc. For the sake of understanding the
derivatives market in India, the data available on SEBI and World Federation of
Exchange ‘s Websites was used extensively.
For the purpose of collecting data, the websites, data centers and data available in
the public domain of the following entities was extensively used:
1. New York Stock Exchange (NYSE)
2. World Federation of Exchanges (WFE)
3. Derivatives and Financial Innovations by Manish Bansal and Navneet
Bansal
4. Derivatives and Risk management by Sundaram Janakiramanan for the
case studies and analysis.
5. Investopedia website to understand the definitions of the products in a
broken down format for deeper understanding and faster analysis.
6. The data has been collected in line with the objectives of study
7. Taking into consideration the nature of study, emphasis was given on the
secondary data.
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8. However, whenever and wherever possible and necessary, the researcher
has used the primary data for the purpose of study.
9. Conclusion has been drawn after a detailed study of financial risk
management techniques adopted by different institutions
10.The review of literature reviews and summarizes the various researches
which have been conducted on the subject of financial risk management.
LIMITATIONS:
1. The study is confined to management of risk only using one tool –
Derivatives. It does not consider the other approaches to risk management.
2. The information collected from various sources are assumed to be true.
3. Lack of primary data for performing the research as more dependency is
on secondary data.
4. The research analysis only focuses on a various sectors of the industry. It
is not a comprehensive report on the risks faced in all the industries and
the tools to mitigate the same.
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CASE STUDIES
1. BMW
OVERVIEW
The BMW Group was a Multinational organization, started by Karl Rapp in
1913 and was involved in the manufacturing of range Automobile Cars and
Motorcycles that grew in subsequent years of operations. In addition to that, it also
provides financial services through leasing and loans, providing as an option for
those customers, who cannot afford to make Full payments on immediate basis.
It also diversifies into international operations due to which its exploits opportunities
through selling in International markets. It also acquired various companies in
international destinations such as the United Kingdom and Germany. Company also
bought the UK based company Rover, through which it acquired the brands like,
Land Rover, MINI, and GM. The company’s goal was to rekindle its existing models
in these brands
THE CASE:
Evaluation of BMW’s transaction and operating exposure
Due to external factors affecting negatively, such as, the ongoing weakening of US
dollar and currencies like, yen in which the company is operating is leading to high
cost of raw materials.
Since the company is buying raw materials for its production from different
countries like Japan, etc. therefore the company’s expenses are in foreign currency
and for which it is subjected to exchange rate fluctuations, which will determine the
operating exposure to BMW.
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Moreover, its operations are in almost all of the major countries around the world
where its sales subsidiaries are located. The revenue generated from these countries
in currencies such as Japanese Yen, US dollars, etc. are then converted into euros as
a base currency. These transactions give rise to transaction exposure where the
transactions are exposed to exchange rate risks.
In order to evaluate these exposures, the complete analysis of transactions related to
sales and manufacturing operations need to be considered. Although the sales are
high enough to cover the high costs of the company but still the deterioration of
foreign currency ratios are exerting pressure on the financial results of the company.
BMW’s hedging strategy
The current hedging strategy of BMW is more like natural hedging strategy.
Considering the current hedging strategy in detail.
Firstly, it uses natural hedging through which the company tries to match the
currency of its operating revenues with its operating expenses in order to cancel out
any exchange rate effects to some extent. Company has issued instructions and risk
figures for its global network, while all of its local treasury centers were to review
the exposure on weekly basis which is then evaluated at the central treasury
department.
Secondly, BMW uses an internally developed model, which it used to plan foreign
exchange hedging. This model shows that an equilibrium rate, for all major
currencies that BMW deals with, indicating their over or undervaluation. The model
mainly focused on long-term hedges usually for six years. The difference between
the equilibrium rate and spot rate are then evaluated for evaluating the exposure.
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When the rate falls below the equilibrium range i.e. 1.15 US$/€ to 1.17 US$/€, the
company then uses forward contracts in order to hedge, while in case of favorable
rates the currency hedges are made to short term.
Apart from this, company also produces a 100% hedge by using two options
consisting of long and short, by which it produces non-zero option, so it incurred no
expense in using them. For example, company receiving the premium on one sold
instrument and on other hand had to pay premium on bought instrument, as a
consequence the premium cancels out the cost leaving the neither company neither
better off nor worse off.
Furthermore, the company also uses ‘cascade strategy’ in order to hedge foreign
currency. In which the initial coverage was less than 100% of the estimates while
for the actual subsequent business years the coverage ratio began to fall. This is
therefore used to evaluate the varying amount of hedging in different periods.
Some of the strategies seem to be good because using options enable the organization
to take advantage of the upside gains from the transaction while hedging against the
downward. In addition to this, it also avoids the premium cost through using two
sided options. However, the internally generated model used was not appropriate
due to operations and changing of exchange rates of related economies.
Appropriateness of Equilibrium Exchange Rate
The range of equilibrium exchange rate as used by BMW as a part of its currency
hedging strategy, that is, 1.15 US$/€ to 1.17 US$/€ might be appropriate in relation
to shorter term expectations of the exchange rates. But for the longer run the range
might become unsuitable for BMW to be used as the equilibrium rate used for
conversions of currency into euros.
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The reasons for the inappropriateness of the equilibrium exchange rate range for its
long-term usage are possibly the fact that economies are exposed to rapid changes
in relation to changes in government policies of the economy. For example, the
determinants that mainly causes the exchange rate to be changes for an economy are
usually based on the effects resulting from the government policies such as, interest
rates, tax rate, management of balance of payments account, national treasury, etc.
and change in any of these can impact the value of the currency leading to changes
in exchange rates.
Since, BMW’s operations are carried out in several economies around the world
which means that the company is not only open to changes in its domestic economic
factors but also due to changes in other economies. Therefore, it can be concluded
that this range may not be appropriate for BMW in the longer-run.
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2. METALLGESELLSCHAFT AG
Losses from Hedging Using Futures
The biggest problem in using futures to hedge is that the hedger will not know
the direction in which the asset price will move. If the price moves against the trader,
there will be gains from futures that will offset losses from the spot price movement.
If the gains from futures exactly offset losses from spot price movement, the hedge
will be a perfect hedge and the trader can fix the price for future purchase or sale of
the asset. In this case, hedging is preferable. However, if the price moves in favour
of the trader, the spot price movement will provide gains. If the trader had used
futures to hedge, hedging will lead to losses. The trader would be better off without
hedging if the price moves in favour of the trader. Hedging when price moves in
favour can lead to huge losses as it happened to Metallgesellschaft.
OVERVIEW
Metallgesellschaft AG, or MG, is a German conglomerate, owned largely by
Deutsche Bank AG, the Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait
Investment Authority. MG, a traditional metal company, has evolved in the last four
years into a provider of risk management services. They have several subsidiaries in
its "Energy Group", with MG Refining and Marketing Inc. (MGRW) in charge of
refining and marketing petroleum products in the U.S. In December, 1993, it was
revealed publicly that the "Energy Group" was responsible for losses of
approximately $1.5 billion. MGRM's expanded venture into the derivatives world
began in 1991 with the hiring of Mr. Arthur Benson from Louis Dreyfus Energy. It
was Benson's strategy that eventually contributed to the massive cash flow crisis that
MG experienced.
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THE CASE:
In December 1993, the energy group of Metallgesellschaft declared that it had made
losses of approximately USD 1.5 billion due to trading in derivatives. But how could
Metallgesellschaft lose so much money? What was their strategy? Metallgesellschaft
committed to sell a certain quantity of petroleum every month for up to 10 years at
prices fixed in 1992. During the early days, the forward price was higher than the
spot price and the company was making up to USD 5 per barrel. In September 1993,
the total number of barrels under the forward contract amounted to 160 million
barrels. These forward contracts also had an option clause attached to them.
According to this option, the counterparty had the right to terminate the contract if
the front-month New York Mercantile Exchange (NYMEX) futures price was
greater than the forward price at which the company was selling the oil. If the
counterparty exercised this option, the company would have to pay one-half of the
difference between the futures price and the forward price multiplied by the volume
remaining to be delivered under the contract. The contract was structured such that
the contract would be terminated automatically if the futures price increased beyond
a specified price.
By offering this type of a contract, the risk of fluctuating oil price was transferred
from the customers to Metallgesellschaft. However, the risk that had been
transferred to Metallgesellschaft had to be managed. The risk management strategy
was as follows:
Use front-month NYMEX futures contracts. The contracts used were unleaded
gasoline and No. 2 heating oil futures. The hedging strategy would be a stack
hedging strategy. This means that the entire hedge will be placed in short-dated
delivery months, instead of spreading into many long dated delivery contracts. At
the maturity of a contract, a position will be taken in the next near month contract or
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the contracts will be rolled over every time a contract for one month expires. This
stack hedging strategy was adopted because of the existence of the option provided,
which was based on the near-month futures. The company went into a long futures
contract. At the same time, it also entered into a swap agreement through which it
would pay fixed energy prices and receive variable energy prices that were based on
the spot price in the market. It held a futures position in about 55 million barrels of
gasoline and heating oil.
This hedging strategy would work as long as the price of oil increased. When one
goes long in futures and if the price increase, the futures position would show a gain
and the balance in the margin account would increase. When the forward contracts
mature, the forward will result in losses, but these losses would be offset by gains
from the futures position. However, if the oil prices dropped, the long futures
position would show a loss and the margin balance would decrease. If the oil prices
dropped further, the margin balance could go below the variation margin and this
would require Metallgesellschaft to provide cash in order to bring it back to the
original margin amount. This would cause a funding problem, because the cash flow
from forward contracts would come in only at the time of maturity of the contract.
This short-term funding problem became very serious in the case of
Metallgesellschaft.
Another problem also arose during this period. The oil market shifted from normal
backwardation to contango. In the oil market, the futures price is generally lower
than the spot price and the market is said to be in normal backwardation. When the
market turns into contango, the futures price would be higher than the spot price. In
the oil market, backwardation can be considered as the market expectation that the
spot prices will fall in the future, as the OPEC's cartel pricing will not be sustainable
over the long run and hence collapse. In 1993, the expectation that the cartel pricing
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would collapse was realized and the spot price decreased, causing the market to be
in contango. When the market is in contango, stack hedging with rollover of
contracts would result in losses that cannot be recovered, as the spot price drops
below the futures price. Thus, as long as the market stayed in contango, the rollover
losses would be heavy. This rollover loss is the real loss suffered by
Metallgesellschaft. The case study shows that the hedge was undertaken in the belief
that the oil price would increase and the market would be in backwardation.
However, the expectations did not realize and the oil prices dropped; this resulted in
margin calls on the futures position and the market went into contango, causing real
losses because of the rolling over of the contracts.
FINDINGS
As we saw in commodity futures, hedging can result in gains when the commodity
price moves against the company that is hedging the risk, as the gain from futures
will offset the loss in the underlying commodity. However, if the price moves in
favor of the company, hedging would result in losses and it would have been better
for the company to not hedge. Thus, beliefs about the direction of price movement
are very important in hedging. The case of Metallgesellschaft showed that the
company made losses of USD 1.5 billion due to hedging using futures, wherein the
price moved in favor of the hedger
In a similar manner, hedging interest rate risk using interest rate derivatives can also
lead to losses if the company hedges the risk and the interest rate moves in its favour.
This is what happened to Orange County, USA, in 1994. The reasons why Orange
County lost USD 1.5 billion
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3. ORANGE COUNTY
OVERVIEW
The sudden plunge of Orange County, Calif., into bankruptcy shook the market
for public borrowing across the country yesterday, threatening to make it more
expensive for many localities to borrow. It also left some Wall Street firms facing
the potential of big losses. It served as a warning of how rapidly new and popular
financial strategies can sour, leaving an apparently prosperous county unable to pay
its bills.
Orange County, a suburban area south of Los Angeles that is more than twice the
size of Long Island's Nassau County, filed for bankruptcy late Tuesday, after heavy
borrowing and risky investments in its investment pool turned into big losers as
market interest rates rose.
The investments had been made by a county desperate to get additional profits on its
investments to pay for government services. But the fund, with about $8 billion
invested in it -- and with borrowings of about $12 billion -- now faces a loss of at
least $1.5 billion. And local governments that invested in the fund may also be
unable to pay their bills, raising the possibility of additional bankruptcy filings.
THE CASE:
On December 1, 1994, Orange County announced that it has accumulated losses to
the tune of USD 1.5 billion through the use of interest rate derivatives while
managing its funds worth USD 7.4 billion
Orange County had a USD 7.5 billion portfolio belonging to county schools, cities
and special districts, and the county itself. The County Treasurer Robert Citron was
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made in-charge of this portfolio and was responsible for investing this amount to
provide reasonable returns to increase the value of the portfolio.
Robert Citron used two strategies to invest his portfolio.
First, he bought government securities with the amount available in his portfolio. He
then borrowed money using these government securities as collateral in a transaction
known as a repo agreement. Although the size of the original investment was only
USD 7.5 billion, the total investment was about USD 20.5 billion, owing to the
leverage he obtained through reverse repos. The additional money borrowed was
also used to buy additional government securities as well as derivative securities
such as inverse floaters, index amortizing notes, and collateralized mortgage
obligations.
An inverse floater is a derivative security on a fixed income security whose coupon
is based on a short-term reference rate, and the coupon decreases with an increase in
the interest rate. The floating rate is determined as: Floating rate Fixed rate - Coupon
leverage Reference rate. The coupon leverage is usually equal to one. If it is more
than one, the floater is called a leverage inverse floater. An inverse floater is a good
instrument as long as the interest rates are either expected to remain constant or
decrease. When the interest rate decreases, the coupon will be higher, and this will
cause the value of the floater to increase. On the other hand, if the interest rate
increases, the value of the floater would decrease. Collateralized mortgage
obligations are bonds that are based on mortgage obligations. As long as there is not
a high level of default on mortgages, these bonds will provide reasonable returns.
On the other hand, if the interest rate increases, the default rate on mortgages would
increase, and this would decrease the value of these bonds
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This strategy worked well for Robert Citron during 1992 and 1993, and he was able
to earn about 2% more than the other county investments. The belief about interest
rates was that the term structure of the interest rates would be upward sloping, and
the lending rate would be more than the borrowing rate. He was using short-term
repos for financing and buying long-term bonds for investment. If the interest rates
remain the same or decrease, the value of the long-term bonds will be higher and the
interest he needs to pay on the repos would be lower, and this would provide higher
gains.
This was a very good strategy that worked well as long as interest rates remained
constant or decreased. However, the major problem with this strategy was that it
would provide losses if the interest rate increased. When the interest rate increases,
the value of the collateral that was put up for the repos will decrease and the
counterparty will ask for more collateral. At the same time, the value of the
investment in bonds such as inverse floaters and collateralized mortgage obligations
will decrease, causing a decrease in the value of the portfolio. When new collateral
needs to be put up, the manager will have to incur a loss on the investment bonds.
In 1994, the Federal Reserve raised the interest rate six times, and as explained
earlier, Robert Citron had to incur losses on his investment derivatives in order to
provide collateral for the repo transactions. The total loss was USD 1.6 billion, and
he could not sell more bonds as there was panic among the bond dealers and the
bond market collapsed.
With such huge losses, Orange County applied for Chapter 11 bankruptcy protection
before it could come out of the crisis. The incurred loss of USD 1.6 billion could not
be recovered.
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4. BARINGS BANK
Losses from Options Trading
The success of most of the trades in which options are used to make money
depends on the direction of movement of the price of the underlying security. As
long as the price of the underlying security moves according to expectations, the
strategy would provide profits. However, if the underlying asset price moves in the
opposite direction, it can lead to losses. Since the profit potential for any of these
strategies is very small, it becomes necessary to engage in a large number of options
contracts or engage in a leverage in order to make large profits. Both of these would
amplify the losses if the underlying asset price moves in the opposite direction.
Therefore, it is necessary to take corrective actions in case the price moves in the
opposite direction. This case shows that trading in options could lead to losses. Nick
Leeson, the one responsible for the collapse of Barings Bank, also used index
futures, which compounded the problem. Therefore, it is important to use derivative
securities, whether options or futures, in a careful manner
OVERVIEW
Founded in 1762, Barings was among the largest and most stable banks in the world.
Barings Banks was a British merchant bank that collapsed in 1995 after one of its
traders, 28-yeaer-old Nick Leeson operating in its Singapore office, lost $1.3 billion.
However, thanks to unauthorized speculation in futures contracts and other
speculative dealings, it ceased operations on February 26, 1995. The direct cause
was its inability to meet its cash requirements following those unauthorized trades.
Even efforts by the Bank of England to arrange a rescue package could not avert the
inevitable collapse.
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THE CASE:
Barings Bank was founded in 1762 and was the oldest merchant bank in Great
Britain. In 1803, it helped the USA in arranging the finances for the Louisiana
Purchase. On February 24, 1995, Peter Baring, the Chairman of the Barings Bank
informed the Bank of England that Nick Leeson, a trader in its subsidiary in
Singapore, had lost a huge sum of money through speculation on Nikkei 225 index
options and futures. Later, it was found that the loss had exceeded USD 1 billion,
leading to the bankruptcy of the bank. But how did Leeson lose so much money?
In 1992, Nick Leeson was posted to Singapore in Barings Futures, which was
established to enable Barings to execute trades on the Singapore International
Monetary Exchange (SIMEX). In 1993, Leeson started trading on the firm's own
account. He started with arbitrage trading, which involved Nikkei 225 stock index
futures and 10-year Japanese Government bond (JGB) futures, which were traded in
both the SIMEX and the Osaka Stock Exchange. Since both the contracts were
traded on two exchanges, the price of these contracts should be the same in both the
contracts. Whenever the price diverged in the two exchanges, arbitrage profits could
be earned at a very low level of risk. Soon, Leeson undertook riskier activities by
betting on the direction of stock price movements on the Tokyo Stock Exchange. He
began selling a large number of straddles on the Nikkei 225 index. A written straddle
would provide profits as long as there is no significant movement in the market in
either direction and as long as the index stays within a given range. In order to
magnify the profits, he entered into a large number of straddles. At one time, he was
short in 37,925 calls and 32,967 puts. He also had a long position in 1,000 Nikkei
225 index futures contracts. The Nikkei index was trading within the range of 17,000
to 20,000, and this written straddle strategy was providing profits for Leeson.
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However, on January 17, 1995, an earthquake struck Kobe and the Japanese stock
market was affected. In a period of five days, the index fell by more than 1,000
points. The written straddle started to provide losses as the index had moved out of
the range in which profits could be made. The wise move for Leeson would have
been to get out of straddles and go long in puts. By going long in puts alone, he
would have made profits when the market went down. However, Leeson believed
that this drop in the market was temporary and the market would soon recover and
go back to the original range. Thus, he kept his position in the straddles. In addition,
he went long in Nikkei 225 index futures, betting that the market index would soon
increase. As the market fell further, he increased his long holding of the index
futures, still believing that the market would go up and that he would make more
profits. By February 23, 1995, Leeson had positions in 61,000 index futures
contracts, which was about 50 per cent of the open interest in the March contract and
24 per cent in the April contract. As the market index fell further, the losses mounted.
The total losses amounted to approximately 927 million British pounds, while the
equity of Barings Bank was only 440 million British pounds. The International
Netherlands Group (ING) assumed the assets and liabilities of Barings Bank
Source: Anatoli Kuprianov, "Derivative Debacles: Case Studies of Large Losses in
Derivatives Markets," Federal reserve Bank of Richmond Economic Quarterly, Vol.
81, No. 4 (Fall 1995): pp1 39.
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5. BLACK MONDAY – NEW YORK STOCK EXCHANGE
Hedging the Value of a Portfolio of Shares Using Index Futures
A portfolio of shares can be hedged by selling an appropriate number of index
futures contracts
However, using index futures contracts to hedge a portfolio has a major problem:
The portfolio to be hedged is typically different from the portfolio of stocks
underlying the index on which the futures are written. This type of hedging is called
cross-hedging, and it involves some basis risk.
OVERVIEW
The New York Stock Exchange (NYSE) is a stock exchange based in New York
City, New York. It is one of the largest facilities in the world for trading stocks and
financial securities. The NYSE is operated by NYSE Euronext, which was formed
in 2007 by the NYSE's merger with the fully electronic stock exchange Euronext.
The NYSE began in 1792 when the Buttonwood Agreement was signed by 24 stock
brokers outside on Wall Street. Trading on the floor was available only to members
who had purchased one of the limited number of "seats."
Monday, October 19,1987 is known as Black Monday. On that day, stockbrokers in
New York, London, Hong Kong, Berlin, Tokyo and just about any other city with
an exchange stared at the figures running across their displays with a growing sense
of dread. A financial strut had buckled, and the strain brought world markets
tumbling down.
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THE CASE:
On October 19, 1987, known as Black Monday, the New York Stock Exchange
witnessed unprecedented activities. The Dow Jones Industrial Average (DJIA)
declined 22.6%, which is the highest single-day drop in history and the NYSE
stopped all trading at 12 noon, instead of the usual 3.30 p.m. closing time. Index
arbitrage, portfolio insurance, and program trading are the reasons attributed to this
decline in the market
At the close of trading on October 16, the market price of the S&P 500 index futures
was below the theoretical value. During the weekend, the Treasury Secretary
announced that the USA will not take any action to boost the value of the U.S. dollar,
which has been at a decline for a while. This remark resulted in the opening price of
stocks in the NYSE on October 19 to be considerably lower than the closing price
on October 16. Typically, futures prices react to market information much faster than
does the stock market and this caused the futures prices in the market to decrease to
a value below its theoretical price. This led to arbitrage opportunities. At the same
time, the portfolio managers also started trading in the index futures. Since portfolio
insurance requires taking a short position in the futures, the demand for short futures
increased, and this caused the futures price to fall further, causing a deviation from
its theoretical value. Since the futures were underpriced in the market when
compared to their theoretical value, arbitrageurs entered the market. Arbitrage
requires that futures are bought and stocks are sold. When stocks were sold, the stock
prices started falling. With the stock price falling, the portfolio insurers started
selling more futures, and this again brought down the market price of the futures to
a level lower than their theoretical value. The aim of the arbitrageurs was to try to
make the futures price the same as their theoretical value; however, this could not
be accomplished because of the actions of the portfolio insurers. Arbitrage was
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automatically done through program trading, and this too could not be stopped.
Continuous sell-off of stocks by portfolio insurers increased the volume of trading
in the stock exchange, and these orders could not be fulfilled as soon as they were
received. This led to a time lag between the time the orders were received and the
time at which they were fulfilled in the stock exchange. Since arbitrage is successful
only when the orders are fulfilled simultaneously in the stock exchange and the
futures market, the arbitrageurs withdrew from the market when they realized that
there was a delay in the fulfillment of orders in the stock exchange. The only
mechanism through which the prices in the stock market and the futures market
could be balanced failed, and the stocks had a free fall. When the volume of
unfulfilled orders increased, the exchange decided to stop trading.
After the crisis, a number of steps were taken to prevent the occurrence of similar
problems caused by program trading. The NYSE prohibited certain forms of
program trading, and the Securities and Exchange Commission (SEC) implemented
circuit breakers: a drop of 350 points in the DJIA would bring a 30-minute halt in
NYSE trading; if the DJIA declined another 200 points, trading would stop for an
hour. Since the implementation of these measures, the NYSE has not experienced
such a crisis again.
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FINDINGS AND CONCLUSION
The following findings are made on the basis of data analysis from the previous
Chapter
1. The study reveals the effectiveness of risk reduction using hedging strategies. It
has found out that risk cannot be avoided. But can only be minimized
2. Through the study. it has found out that, the hedging provides a safe position on
an underlying security. The loss gets shifted to a counter party. Thus the hedging
covers the loss and risk. Sometimes, the market performs against the expectation.
This will trigger losses. so the hedger should be a strategic and positive thinker.
3. It has been found that, all the strategies applied on historical data of the period of
the study were able to reduce the loss that rose from price risk substantially.
4. If the trader is not sure about the direction of the movement of the profits of the
current position, he can counter position in the future contract and reduces the level
of risks.
5. In general, the anticipation of the strategies purely for return enhancement is a
risky affair, because, if the anticipation about the performance of the market and the
underlying goes wrong, the position taker would end up in higher losses as explained
in the case studies, resulting in a failure of the respective company.
Risk is a situation where actual outcome may deviate from expected outcome. Risk
is categorized into two forms such as internal risk and external risk. Risk
management refers to the process of understanding, mitigation and sharing of risk.
This is not about to see what will happen in future, instead it deals to work out in
advance what might happen. Therefore, it is called as proactive management rather
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than reactive. Risk management plays a key role in the financial industry and an
integral part of it. Markets and risk management practices grow with the progress of
business. The growth of the business and market expansion pose challenges for
managing the risk. As a result, financial instruments evolved to manage the risks
which are known as financial derivatives. There are different forms of contract but
most common forms include futures, forwards, options and swaps. Exchange traded
derivatives are those which are traded through stock exchange. On the other hand,
over the counter derivatives are those financial instruments whose terms and
conditions are settled between two parties through negotiation. Although, the core
purpose of derivatives is to control the certain level of risks but they are also utilized
for the purpose of speculative activities by taking more risk in order to increase the
return. Therefore, whether activity is trade base or over the counter, firms are in
position to mitigate their risk with the help of financial derivatives. So, it is not hard
to say that financial derivatives play a key role in emerging markets. There are
various approaches to estimate the risk but in this paper, VaR has been used to
measure the risk. Financial derivative is a tool used by the companies to manage the
risk. In simple word, it is used to hedge the risk which is being faced by the company.
There are two important functions which are played by the financial derivatives
namely hedging and speculation. Hedge instruments are used with an attempt to
reduce the risk level attached with the underlying transactions. Hedgers protect their
assets or liabilities from the adverse change by entering into derivative contract.
Speculation presumes the financial risk with the prediction of gain from market
fluctuations. Therefore, financial derivative play key role for managing risk. The
efficient use of financial derivatives reduces risk level and increases rate of return.
Thus, it is improving the financial health of business and climate.
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BIBLIOGRAPHY
Books:
Derivatives and Financial Innovations by Manish Bansal and Navneet Bansal
Futures and Options by N.D. Vohra and B.R. Bagri
Portfolio Management Handbook by Robort. A. Strong
Derivatives and Risk management by Sundaram Janakiramanan for the case
studies and analysis.
Websites:
www.world-exchanges.org
www.nyse.com
www.investopedia.com
www.nytimes.com
www.economictimes.indiatimes.com
www.worldscientific.com
www.learning.oreilly.com
www.corporatefinanceinstitute.com
www.efinancemanagement.com
www.hdfcfund.com
www.moneycontrol.com
www.simplilearn.com
www.walstreetmojo.com
www.investor.gov
www.investprogram.org