Derivatives are contracts whose value is based on an underlying asset. Common types include forwards, futures, options, and swaps. Forwards and swaps are bilateral contracts while futures are exchange-traded. Options provide the right but not obligation to buy or sell an asset. Derivatives help manage various types of risk, including systematic risks like market risk and interest rate risk, as well as unsystematic risks like business and financial risk. They improve price discovery, enhance market liquidity, and allow flexible risk management strategies like hedging.

1. Importance of
Derivatives in
Risk Management

2. WHAT IS A DERIVATIVE ?
 A derivative is a contract between two or more parties whose value is based
on an agreed-upon underlying financial asset

3. TYPES OF DERIVATIVES
 Forwards
 Futures
 Options
 Swaps

4. FORWARD
A forward contract is a contract between two parties, where settlement takes
place on a specific date in future at a price agreed today. The main features
of forward contracts are
They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed.
The contract price is generally not available in public domain.

5. FUTURE
A futures contract is an agreement between two parties to buy or sell an asset
at a certain time in the future for a certain price.
Unlike forward contracts, futures contracts are normally traded on an
exchange.

6. OPTION
• An Option contract is a contract between two parties whereby one party
obtains the right but not the obligation to buy or sell a particular asset at a
specified price on or before a specified date
• Options can be traded in both OTC market and exchange traded markets.

7. TYPES OF OPTION
• CALL OPTION: Call option gives the holder the right to buy the underlying
asset by a certain date for a certain price.
• PUT OPTION: Put option gives the holder the right to sell the underlying
asset by a certain date for a certain price.

8. SWAP
• A swap is a derivative contract made between two parties to exchange cash
flows in the future.
• Interest rate swaps and currency swaps are the most popular swap contracts,
which are traded over the counters between financial institutions. These
contracts are not traded on exchanges.

9. RISK MANAGEMENT
Expected return is the uncertain future return that an investor expects
to get from his investment.
Risk is the potential for variability in returns.
Risk management is the human performance which incorporates
identification of hazard, assessment of risk, improving plans to control it.
Elements of Risk :
❶ Systematic Risk
❷ Unsystematic Risk
 i.e. Total Risk = Systematic risk + Unsystematic risk

10. SYSTEMATIC RISK
The variability in security returns caused by external factors such as economic,
political and social systems is referred as Systematic risk(𝜷)
𝜷 =
𝜸im 𝝈i 𝝈m
𝝈2
m
 𝜸im- Correlation coefficient between the returns of stock i and returns of
the market index.
 𝝈i-standard deviation of returns on stock i.
 𝝈m-Standard deviation of the returns of the market index.
 𝝈2
m-Variance of the market return.

11. Contd..
Systematic risk is divided into three
i. Interest rate risk: Type of systematic risk that particularly affects debt
securities like bonds and debentures.
E.g.: Bond having face value 1000Rs; coupon rate =10%; market interest
rate=10% then the market price will be (
100
10
× 100) = 1000rs
if the market interest rate moves up to 12%,then market price will be
(
100
12
× 100) = 833.33rs

12. Contd..
ii. Market risk:
-Type of systematic risk that affects shares.
-Market price may go up & down
iii. Purchasing power risk:
-It refers to the variation in investor return caused by inflation
-Inflation Purchasing power of money
-Two important sources of inflation are rising costs of production &
excess demand for goods and services in relation to their supply

13. UNSYSTEMATIC RISK
When variability of returns occurs because of internal factors such as
raw material scarcity, labour strike, management inefficiency is known
as Unsystematic Risk.
It is divided into two
i. Business Risk: It is a function of the operating conditions faced by a
company and is the variability in operating income caused by the
operating conditions of the company.
ii. Financial Risk: It is the risk originates due to the inclusion of debt
capital in the capital structure
Debt capital Financial risk

14. FUNCTIONS OF FINANCIAL DERIVATIVES
• Helps in control, avoid, shift and manage efficiently different types of risks
through various strategies like hedging, arbitraging, spreading.
• Enables to discover or form suitable or correct or true equilibrium prices in
the market.
• Helps in enhancing liquidity and reduce transaction costs in the markets.

15. CONT…
• Helps investors, traders, and managers to devise strategies so that asset
allocation makes easier.
• Smoothen out price fluctuations and squeeze the price spread, integrate price
structure at different points of time.
• Helps in encouraging the competitive trading in the markets different risk
taking by speculators, hedgers and encourages young investors and
professionals.

16. THANK YOU
HAPPY TRADING …….