FIG09105: Financial Risk Management

DR. Dionis J. Ndolage

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 HEDGING RISK WITH DERIVATIVES
Topics covered
(1)Introduction
(2) What are Derivative
(3)Benefits of Derivative Products
(4)Players in Derivative Markets
(5) An overview of main derivative Products
(6) Detailed accounts on the main Derivative Products
(7) Risk associated with Derivatives.

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1. INTRODUCTION
 One of the function of the financial manager is Risk
Management. This involves;
(i) Identifying the different types of risks that the firm is
facing
(ii) Assess the extent of exposure/Risk
(iii) Monitoring on continuous basis the risk encountered.
(iv) Taking measure to control or hedge/ minimize the risk
involved.
 Some of the financial instruments used for hedging
risks are DERIVATIVES

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2. What are Derivatives?
 DERIVATIVES are synthetic financial products or
instruments which are traded as financial contracts
that safeguard the value or price of the underlying
currencies, securities or commodities that are to be
transacted or delivered during a contracted period or
at a specified future date.
 Derivatives as their name imply derive their value
from the underlying securities, currencies or
commodities that are traded in the financial or
commodity markets.

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2. What are Derivatives? Cont….
 Derivative products protect market participants
against risk associated with adverse movements
in interest rates, exchange rates and changes in
the future prices and values of securities,
currencies and commodities that are to be
delivered at forward or future dates.
 For a small price, the fees of premium, or one
can protect the underlying assets of substantial
value.

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2. What are Derivatives? Cont….
 For a premium, contract writers or hedgers are
prepared to bear risks on the behalf of other market
participants.
 They offer some derivatives products such as:
(a)Forward rate contracts
(b)Forward rate agreements
(c)Financial Options
(d)Financial futures
(e)Swaps and

(f)Credit derivatives.
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(3)Benefits of Derivative Products (DPs)
(a)DPs are comparatively cheaper than their
underlying securities. For a small fee or
premium, one can protect securities of
substantial value.
(b)DPs can be flexibly structured to meet specific
requirements of the parties to the forward
contract in terms of amount involved,
currencies, rates (interest and exchange),
maturity and delivery periods (e.g., forwards)

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(3)Benefits of Derivative Products (DPs) Cont..
(c) There is a wide choice of derivative products for which
buyers can choose from organized exchanges and OTC
markets
(d) Used to hedge/ share against financial risks –
associated with adverse movements in interest rates,
exchange rates and prices – provide a more efficient
allocation of economic risks.
(e) From (d) above, derivatives enable firm to plan with
certainty. Buyers of DPs are assured to get the
contracted value of the underlying securities or
commodities or to make transactions at contracted
interest and exchange rates and prices.
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 (3)Benefits of Derivative Products (DPs) Cont…
(f) Implementation of assets allocation
decision/strategies – enable low cost
diversification and leverage + provide a wide
choice of financial asset classes and hence
increased potential for diversification.
(g) Price discovery and increase liquidity – they provide
information about prices movements of underlying
assets.
(h)DPs enable f/institutions to make non-interest income
in form of fees, premiums or commissions (off-balance
sheet income).
(i) Derivatives as forward products are traded to
generate cash flows and profit ( if not used
well can generate huge losses and risks.

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(4)Players in Derivative Markets
 Main players in Derivative Markets are;
(i)Banks
(ii)Financial institutions
(iii)Security firms / IBFs
(iv)Companies
(v)Investors
 Can be: buyers, sellers, intermediaries, hedgers
and Speculators.

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(5)An Overview of Main Derivative Products
(i)OPTIONS - is a contract giving one party the right, but
not the obligation, to buy (call option ) or currencies,
commodities or some other underlying asset, at a
given price, at or before a specified dates.

(ii) FUTURES – Are agreements between two parties to

undertake a transaction at agreed price, interest or
exchange rate on a specified data ( it is an obligation).
Futures are exchange – traded.

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(5)An Overview of Main Derivative Products Cont…
(iii) FORWARDS – Are agreements between two parties
to undertake an exchange at an agreed date at a
price agreed now. Forwards are private agreements
and are OTC –traded.
(iv) SWAPS – Involve exchange of debt repayment
obligations.
(a) Interest Rate Swaps – involve the exchange of
interest obligations, e.g., Fixed vs Floating, Short-
term vs Long-term obligations, Floating to Floating
obligations (basis swaps).

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(5)An Overview of Main Derivative Products Cont…
(iv) SWAPS Cont…
(b) Currency Swaps – Involve the exchange of currencies
and interest obligations denominated in different
currencies.
 Can be : Sell/Purchase Swaps or Purchase/ Sell Swaps.
(c) Credit Swaps/ Credit Default Swaps (CDS) – Is a
financial swap agreement that the seller of the CDS will
compensate the buyer in the event of debt default or
other credit event.
 That is, the seller of the CDS insures the buyer against
some reference asset defaulting.
(5) An Overview of Main Derivative Products Cont…
(iv) SWAPS Cont…
 The buyer of the CDS makes a series of payments (the
CDS ‘’fee’’ or ‘’spread’’) to the seller and, in exchange,
may expect to receive a payoff if the asset defaults.

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(5)An Overview of Main Derivative Products Cont…
(v) FORWARD RATE AGREEMENTS (FRAs).
 Are arrangements where one part(e.g., a bank )
compensate the other party (borrower or
depositor against the rise or fall of interest rate
over the agreed rates.
 Can be: Caps (maximum) or Floors (minimum)
or a combination of the two which referred to
as Collar structure.

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(5)An Overview of Main Derivative Products Cont…
(vi) CREDIT DERIVATIVES – Are used as a means of
protecting against credit risk.
 Are essentially securities with a pay-off linked to
a credit event e.g., borrowers default, credit
rating downgrading or a structural change in a
security containing risk.
 In credit derivatives, there is a party (or bank)
attempting to transfer credit risk, known as protection
buyer, and another party/bank (counter party)
attempting to acquire credit risk, known as protection
seller.
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(5) An Overview of Main Derivative Products Cont…
(vi) CREDIT DERIVATIVES Cont…
 Credit derivatives are usually transacted on unfunded
basis (in some cases, may be funded) – where the
protection seller is not mandated to put in any funds
upfront. It is only the protection buyer who is required
to pay periodic premiums.

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Thank you for Listening

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