Derivative and Risk

Management
Risk management
• Risk management is: ‘A process of understanding and
managing the risks that the entity is inevitably subject to in
attempting to achieve its corporate objectives. For Management
purposes, risks are usually divided into categories such as
operational, financial, legal compliance, information, and
personnel, one example of an integrated solution to risk
management is enterprise risk management.
Importance of Risk Management
• Derivatives play a critical role in risk management by allowing
investors to hedge against potential losses in underlying assets.
They can be used to protect against various types of risks such
as interest rate risk, currency risk, commodity price risk, etc.
Risk Management Process
1. Risk Identification:
• Market Risk: This includes risks related to changes in market prices,
such as interest rate risk, currency risk, commodity price risk, and
equity price risk. For example, interest rate derivatives are exposed
to fluctuations in interest rates.
• Credit Risk: Derivatives involve counterparty risk, where the other
party may default on its obligations. Credit risk assessment is
essential to evaluate the financial health of counterparties.
• Liquidity Risk: This refers to the risk of being unable to buy or sell a
derivative at a fair price due to a lack of market participants or depth.
• Operational Risk: Risks related to internal processes, systems, and
human errors that can affect derivative trading and settlement.
2. Risk Assessment:
• Quantitative Analysis: Using mathematical models and
statistical tools to quantify risks, such as Value at Risk (VaR)
models, stress testing, and scenario analysis.
• Qualitative Analysis: Considering qualitative factors like
regulatory changes, geopolitical events, market sentiment, and
industry trends that can impact risk levels.
3. Risk Mitigation:
• Diversification: Spreading investments across different types of
derivatives, asset classes, industries, and geographies to reduce
concentration risk.
• Hedging: Using derivatives to offset risks in the underlying assets.
For example, using futures contracts to hedge against commodity
price fluctuations.
• Counterparty Risk Management: Employing measures like
collateral agreements, credit limits, and monitoring to mitigate the risk
of counterparty default.
• Risk Transfer: Utilizing instruments like insurance, options, and
swaps to transfer specific risks to other parties willing to bear them.
4. Risk Monitoring:
• Regular Monitoring: Continuously monitoring market conditions,
portfolio performance, and risk exposures to ensure they remain
within acceptable limits.
• Stress Testing: Simulating extreme scenarios to evaluate how the
portfolio would perform under adverse conditions.
• Feedback Mechanisms: Incorporating feedback from risk
assessments, trading activities, and market developments to refine
risk management strategies.
• Compliance and Reporting: Adhering to regulatory requirements for
risk reporting and maintaining transparency with stakeholders about
risk exposure and mitigation efforts.
What is an option?
• An option provides the holder with the right to buy or sell a
specified quantity of an underlying asset at a fixed price (called
a strike price or an exercise price) at or before the expiration
date of the option.
• Since it is a right and not an obligation, the holder can choose
not to exercise the right and allow the option to expire.
• There are two types of options - call options (right to buy) and
put options (right to sell).
Some important terms

∙ Option: An instrument that provides its holder with an opportunity to buy or sell a specified asset at a stated
price on or before a set expiration date.
∙ Exercise price: It is also known as striking price that is specified in the option contracts at which the option
buyer can exercise his/her right to buy or sell the securities.
∙ Expiration date: It is also known as the maturity date or exercise date. It is the specified date in the options
contract by which the option can be exercised.
∙ Option premium: It is also known as option price that the option buyer pays to the option seller in both call
and put options. It will have to be paid, generally in advance, whether or not the holder exercises his option.
∙ Option holder/option buyer: Buyer of an option is the one who buys the right to purchase/sell securities by
paying the option premium.
Some important terms
∙ Option issuer/option writer/option seller: Writer of an option is the one who receives the option premium
and is thereby obliged to sell/buy the securities if the option holder exercises the option on him.
∙ At-the-money option: It is an option that would lead to zero cash flow (no profit no loss) to the option
holder if it were exercised immediately.
∙ In-the-money option: It is an option that would lead to a positive cash flow to the holder if it were exercised
immediately.
∙ Out of the money option: It is an option that would lead to a negative cash flow to the option holder if it
were exercised immediately.
Types of option

Option

Call Put

Europea
American
n
Europea
American
n
European and American Option
European and American style options are not regional options.
They are terms used to describe two different types of option
exercise. European Style Options: can be exercised only at
expiration. American Style Options: can be exercised at any time
prior to expiration.
Call Options
• A call option gives the buyer of the option the right to buy the
underlying asset at a fixed price (strike price or E) at any time prior
to the expiration date of the option. The buyer pays a price for this
right.
• At expiration,
• If the value of the underlying asset (Po) > Strike Price(E)
• Buyer makes the difference: Po - E
• If the value of the underlying asset (Po) < Strike Price (E)
• Buyer does not exercise
• More generally,
• the value of a call increases as the value of the underlying asset increases
• the value of a call decreases as the value of the underlying asset decreases
Value of Call Option
• The value of an option is also known as theoretical value. The following equation defines the
theoretical value of an option.

• Vc = Max. (Po – E, 0)

• Where,
• VO = value of call option at their expiration date
• Max. = maximum value
• Po = market price per share
• E = exercise price per share
• Max. (Po – E, 0) = maximum value of Po – E or 0 whatever is greater
Profit and Loss of the Call Option Buyer

• The investor that expects the price of a particular security rise, also called bullish investor, buys a
call option. If the price actually rises as expected, the investor will exercise the option and buys the
security at stated price. However, if the price decreases, the investor discard the option losing only
premium paid for the option. Since, there is no limit to which price of stock increases, the profit of
call option buy will increase significantly.
• Profit (Loss) for Call Option Buyer = Vc – Premium (P)
Payoff Diagram on a Call option Buyer
Profit and Loss of the Call Option Seller (Writer)

• The call option seller or writer has the obligation to sell the stock. He expects that the price of
security will fall. Hence, if price of stock decreases the call option buyer won’t exercise the option.
In that case, the seller will make a profit equal to the premium. However, if the price of security
increases, the loss of call seller increases tremendously.
• Profit (Loss) for Call Option Buyer = Premium (P) – Vc
Payoff Diagram on a Call option Seller
Breakeven Point for Call Option Buyer and Seller

• The breakeven price is the price of an option at which call buyer and seller makes no profit and no
loss. When the market price of stock increases to exercise price plus premium (E+P), both call buyer
and seller will break even.
• Breakeven point = Exercise price (E) + Premium (P)
Put option
• A put option gives the buyer of the option the right to sell the
underlying asset at a fixed price at any time prior to the expiration
date of the option. The buyer pays a price for this right.
• At expiration,
• If the value of the underlying asset (Po) < Strike Price(E)
• Buyer makes the difference: E-Po
• If the value of the underlying asset (Po) > Strike Price (E)
• Buyer does not exercise
• More generally,
• the value of a put decreases as the value of the underlying asset increases
• the value of a put increases as the value of the underlying asset decreases
Value of Put Option
• The value of an option is the theoretical value and it is mostly dependent on the market price. The
following equation defines the value of put option.

• Vp = Max. (E – Po, 0)
• Where,
• Vp = value of put option at their expiration date
• Po = market price per share
• E = exercise price per share or strike price per share
• Max. (E – Po, 0) = maximum value of (E – Po) or 0 whatever is greater
Profit/Loss to Put option Buyer
• The investor that expects the price of a particular security decrease, also called bearish investor, buys
a put option. Since, put option gives the buyer right to sell the stock at set price, when market price
decreases, buyer makes profit. If price of stock increases, it will be unprofitable for the buyer to
exercise the option. In that case, the option seller will make a profit equal to the premium.
• Profit (Loss) for Put Option Buyer = Vp – Premium (P)
Payoff Diagram on a Put option Buyer
Profit and Loss of the Put Option Seller (Writer)

• If the price of stock increases the put option seller makes a profit equal to option premium. However,
if the price decreases, the seller incurs loss.
• Profit (Loss) for Put Option Seller = Premium (P) – Vp
Payoff Diagram on a Put option Seller
Exercises
• A call option exists on Kala Corporation its price of stock is Rs 80 and an option
has an exercise price of Rs 60.
a. What is the theoretical value of the call option?
Exercises
Given the following data, determine the value of the call options at their expiration dates.

Option Market price per share at the expiration date Exercise price of the option
A Rs 20 Rs 12
B 30 35
C 5 15
D 15 5
A forward contract

∙ A forward contract is a private agreement between two parties to

buy or sell an asset (such as commodities, currencies, stocks, or
bonds) at a specified price (the forward price) on a future date
(the delivery date).
∙ These contracts are customized and are not traded on
exchanges. They are typically used by businesses and investors
to hedge against price fluctuations or to lock in prices for future
transactions.
futures contract

∙ A futures contract is similar to a forward contract but is

standardized and traded on organized exchanges.
∙ In a futures contract, the buyer and seller agree to buy or sell a
specific quantity of an asset at a predetermined price on a
specified future date.
∙ Futures contracts are often used for hedging purposes by
producers, consumers, and investors to manage price risks
associated with commodities, currencies, interest rates, and stock
indices.
Swap

∙ A swap is a financial derivative contract between two parties to exchange cash flows
or liabilities over a specified period.
∙ Common types of swaps include interest rate swaps, currency swaps, and
commodity swaps.
∙ In an interest rate swap, for example, two parties agree to exchange fixed-rate and
floating-rate interest payments based on a notional principal amount.
∙ Swaps are used to manage risks, alter cash flow structures, or take speculative
positions in various markets.
Forward Contracts vs. Futures Contracts:

∙ Similarities:
∙ Both are agreements to buy or sell an asset at a specified price at a future
date.
∙ They are used for hedging and speculative purposes.
∙ Differences:
∙ Futures contracts are standardized and traded on exchanges, while forward
contracts are customized agreements between two parties.
∙ Futures contracts require margin deposits, daily mark-to-market, and are more
liquid, whereas forward contracts do not have these features.
∙ Forward contracts offer more flexibility in terms of customization and negotiation
of terms.
Forward Contracts vs. Options:

∙ Similarities:
∙ Both are derivative contracts used for hedging or speculation.
∙ They involve the right to buy or sell an asset at a specified price.
∙ Differences:
∙ Options provide the right but not the obligation to buy or sell, while
forward contracts have an obligation.
∙ Options have an expiration date after which they become worthless,
whereas forward contracts must be fulfilled at the agreed-upon future
date.
∙ Options involve paying a premium, while forward contracts do not require
an upfront payment.
Forward Contracts vs. Swaps:

∙ Similarities:
∙ Both are derivative contracts used for managing risk.
∙ They involve agreements between two parties.
∙ Differences:
∙ Swaps involve the exchange of cash flows or liabilities based on different
financial instruments or variables, while forward contracts focus on the
delivery of an underlying asset.
∙ Swaps can be more complex and involve multiple cash flows over time,
whereas forward contracts typically involve a single transaction.
 •Advantages of Using Forward Contracts for Risk Management:
1. Customization: Forward contracts can be customized to specific needs,
allowing parties to tailor the contract terms to their exact requirements.
2. Flexibility: They offer flexibility in terms of asset type, quantity, delivery date,
and other contract specifications.
3. Cost-Effective: Since forward contracts are bilateral agreements without
exchange-traded features like margin requirements, they can be cost-effective
for managing specific risks.
4. Price Certainty: Forward contracts provide price certainty as both parties agree
on the price upfront, which can be beneficial for budgeting and planning.
 •Limitations of Using Forward Contracts for Risk Management:
1. Counterparty Risk: There is a risk of default by the counterparty, especially if
it's a non-regulated or less creditworthy entity.
2. Lack of Liquidity: Forward contracts are not as liquid as exchange-traded
derivatives like futures, which can make it challenging to exit or modify
positions.
3. Fixed Obligation: Once entered into, the parties are obligated to fulfill the
contract, which may not always be advantageous if market conditions change
significantly.
4. No Flexibility After Execution: Unlike options, forward contracts do not
provide the flexibility to change or cancel the contract once it's executed, which
can be a limitation if circumstances change.