CHAPTER 1

DERIVATIVES – AN
INTRODUCTION

Derivatives and Risk Management

Copyright © Oxford University Press
By Rajiv Srivastava
 Risk
2

 Risk can be defined as deviations of the actual results

from expected.
 Risk can be classified two ways – 1) risk of small losses
with frequent occurrence and 2) risk of large losses with
infrequent occurrence.
 The impact or magnitude of risk is normally estimated
from following two factors
1. The probability of an adverse event happening, and

2. In case the event occurs the magnitude of the loss it

can cause.

Derivatives and Risk Management Chapter 1

By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Managing Risk
3

 The ways to manage risk include attempt to control

potential damage, diffuse, diversify and transfer
risk to those willing to accept it.
 One can manage the risk by transferring it to
another party who is willing to assume risk.
Insurance company does not do anything to contain
the risk per se but assumes risk on your behalf.
 Management of risk through derivatives is commonly
referred as hedging which enable offsetting of risk
emanating from one situation.
Derivatives and Risk Management Chapter 1
By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Types of Risks
4

 Business risks are characterised by small losses but with

high probability
 The risk of large losses with small probability is
normally referred as event risk.
 Event risk is normally managed by insurance. companies
and
 Business risk is concerned about
 Changes in prices,
 Changes exchange rates, and
 Changes in interest rates.

Derivatives and Risk Management Chapter 1

By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Derivatives
5

 Three kinds of business risk of price, exchange rate

and interest rate can be managed through products
that are classified as derivatives.
 Derivatives are products that derive their value
from some other asset called underlying asset but in
other aspects they may remain distinctly different
from and independent of the underlying asset.

Derivatives and Risk Management Chapter 1

By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Derivative Products
6

 Variety of derivatives are available both standard

product as well as tailor-made, to suit various
applications.
 Four broad types of instruments are:
 Forwards

 Futures

 Options, and
 Swaps,

Derivatives and Risk Management Chapter 1

By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Classification of Derivatives
7

Based on the underlying asset Based on how traded

The underlying asset can Derivatives can be traded

be either on the exchange or
 Commodities OTC
 Currencies  Over-the-counter

 Shares/Indices
(OTC)
 Exchange Traded
 Interest Rates

 Credit

 Weather
Derivatives and Risk Management Chapter 1
By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Participants in Derivative Markets
8

Hedgers: are those who use derivatives for hedging i.e.

reduce or eliminate risk.
Speculators: are those take positions in derivatives to
increase returns by assuming increased risk. They
provide much needed liquidity to markets.
Arbitrageurs: are those who exploit mispricing in
different markets; They assume riskless and
profitable positions.
All 3 participants are essential for efficient functioning.
Derivatives and Risk Management Chapter 1
By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Functions of Derivatives
9

3 major functions of derivatives are:

 Enable price discovery

 Facilitate Transfer of Risk

 Provide Leverage

Derivatives and Risk Management Chapter 1

By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press
 Misuses & Criticism of Derivatives
10

 Increased volatility: Though used for efficient price

discovery, derivatives when used as a speculative
product can make increase volatility in prices.
 Increased bankruptcies: Derivatives being leveraged
products have caused disproportionate positions
leading to several disasters and bankruptcies.
 Increased burden of regulations: Most derivatives
hide more than they reveal. For financial discipline
and better disclosures new rules have to be devised.
Derivatives and Risk Management Chapter 1
By Rajiv Srivastava Derivatives – An Introduction
Copyright © Oxford University Press